The stock market is one of the best avenues to invest your money. It offers inflation-beating returns, helping investors build their corpus. Irrespective of whether you're a beginner or a seasoned investor, timing the market is critical. To make money off the stock market, you need to have a basic understanding of how the stock market works.
While it's not possible to predict how the market will move, you can build the skills necessary to analyse it and enjoy high returns. When it comes to analysing the stock market, the two popular approaches are fundamental analysis and technical analysis.
Here, in this guide, we explain how both these approaches work and explain the fundamental differences between both so that you can choose the best one that works for you.
What is fundamental analysis?
As the term implies, fundamental analysis is analysing the fundamentals of a company before you purchase its stocks. It involves evaluating the past and current performance of a company to determine how it will perform in the future.
Fundamental analysis involves the study of a company's assets, liabilities, earnings, debt, reserves and other financial metrics to evaluate the real value of its stock. It also considers the economic health of the company's industry/niche, the overall economy of the country to get a holistic view of the actual value of the stock.
Once all these factors are considered, investors can arrive at an appropriate price for the stock of the company. If the current market value is lesser than this price, then the stock is identified as undervalued. Buying undervalued stocks is a good decision, as it has huge probabilities of providing good returns in the future.
On the other hand, if the current market price of the stock is more than the predicted rate, then the share is earmarked as overvalued. Investors then hold off purchasing overvalued stocks. On the other hand, selling overvalued stocks is a reasonable proposition.
Pros and Cons of Fundamental Analysis
Advantages of Fundamental Analysis
It gives a comprehensive picture – as it considers all elements like the economy, the company's sector, performance, ethos of the company and more.
It helps in finding the actual price of a company’s stock in the long-term.
Disadvantages of Fundamental Analysis
Since fundamental analysis is done using public information available to all, it doesn't offer a significant advantage to the analyser.
The success of fundamental analysis depends mostly on the skill of the analyser.
It cannot pinpoint the right moments for entry/exit in the market.
It cannot be applied to short-term investments.
Additional Reading: 10 golden rules of investing in stock markets
What is technical analysis?
Technical analysis is another approach to predict the future trends of a stock based on its historical performance. In this approach, investors study the price and volume patterns of a stock. This analysis helps investors make smart inferences by studying the ups and downs of the price of the stock.
For instance, if a stock is highly volatile (experiencing lower lows and higher highs), then the investor may decide to purchase it to benefit from the volatility. On the other hand, if the stock experiences a sharp decline in price, the investor may rely on the enveloping candle pattern and sell it at the right time to cut losses.
At first glance, it can be understood that technical analysis is scientific and relies on clear-cut methods and definitions. On the other hand, fundamental analysis is more subjective.
Pros and Cons of Technical Analysis
Advantages of Technical Analysis
Clear picture – Since it observes the price movements of stocks on scientific charts, it gives a clear picture of market conditions.
It provides investors with objective data, which they can rely on.
It identifies patterns on a chart helping investors make a smart buy and sell decisions.
Inexpensive – Investors can quickly get started with technical analysis using readily available software.
Now, let’s look at the drawbacks of technical analysis.
Disadvantages of Technical Analysis
There are too many indicators, which can lead to analysis paralysis for investors.
It fails to consider the underlying fundamentals of a company.
Fundamental vs Technical Analysis – The Differences
Fundamental and technical analysis are not just two different methodologies for identifying winning stocks. They are two unique approaches that serve different categories of investors. Here are a few points that help you understand the differences between these two approaches.
Fundamental analysis is best suited for investors who are looking to stay invested for a long-term. It helps in predicting the market price of a company's stock in the long-run. On the contrary, technical analysis is most suited for determining the price movements of share in the short-term. Hence, technical analysis is mostly used by day traders.
As you can see, the period of investment plays a crucial role in determining the right methodology. Technical analysis is done using charts. Since these charts are volatile and change within a short period, technical analysis is mostly useful for short-term investments. On the other hand, the fundamentals of a company do not often fluctuate and remain intact for several years. Hence, this methodology is ideal for long-term investments.
Investors can choose the right methodology based on their investment goals. For instance, if the investor is looking to sell the stock after a short period, then he may opt for technical analysis. On the other hand, if the investor is investing to achieve long-term goals, they may choose for fundamental analysis.
Understanding your investment goals and investment horizon helps in the natural selection of the right analysis methodology.
Now that we have seen the differences between fundamental and technical analysis, the next question you're likely to have is – which methodology is better? Let's answer this question in the following section.
Addtional Reading: What are the different type of stocks
Which is the better methodology? Fundamental or Technical Analysis?
Both technical and fundamental analysis are two unique approaches that cannot be compared. It’s not possible to state that one methodology is superior to the other. They are both valid and useful and take a different approach to market analysis.
Finally, choosing the right methodology depends on the investor’s purpose and time horizon. To state it in general terms, technical analysis is more suited when the investment horizon is short-term. On the other hand, if the investment horizon is long-term, then fundamental analysis cannot be ignored.