Whether you are a short term or a long term investor, we all have the same basic questions about investing in the stock market. How do we determine whether or not to invest in a company or a currency or any other financial product? What information will you use to make your buy and sell decisions? There are two primary schools of thought regarding company analysis – fundamental and technical analysis.
Fundamental analysis generally refers to the study of the economic factors underlying the price movement of a stock. For the most part, this form of analysis usually results in longer-term investments and is considered to be a more conservative approach. Fundamentalists attempt to quantify the current value of a stock by gathering data relating to general industry outlook, overall market conditions, corporate financial strength, historical patterns of sales, earnings, market share, dividends, etc. Using this data they then try to assign a future value to the stock by interpretation and projection.
The difference between the current and future values reflects the fundamentalist’s assessment of the stock’s potential as an investment opportunity. Investment decisions are made based on this fundamental information relative to other opportunities.
Fundamental analysis involves looking at the nature of the thing itself. In the case of a company, it would mean looking at how the company has performed in the past and determining whether that investment is likely to go up or down, based on the price in comparison with the “intrinsic” value of the investment.
If a company’s balance sheet across some time shows a consistent profit and its stock is undervalued, then this would be a good investment because the price of the stock is likely to go up, to reflect the higher intrinsic value of the company. Likewise, if the financial history of the company shows little profit or even significant loss, then overpriced stock in this company is likely to go down in price and it would be a poor choice for investment.
Another way to gauge the value of a company is through technical analysis. While fundamental analysis uses information that is available across large periods of time such as quarters or fiscal years, technical analysis looks not at the thing itself but at the market for the thing. A company may have consistent profit but the price of the stock may not rise for any number of reasons.. Technical analysis generally concentrates on the study of historical price and volume data to detect future trends.
Technical analysis is based on the following three principles:
1. Everything relevant to the value of a company’s stock is discounted and reflected in share price.
2. Trends sometimes appear in share price moves and when once started, these trends tend to persist.
3. Activity in the market repeats.
The purpose of technical analysis is to detect the trend or momentum of a stock early so that a good entry or exit point can be selected. Traditionally, charting is the main approach for technical analysis. However, interpreting a chart or an indicator is, at least in part, a subjective issue. Even if you have the knowledge and experience to understand what a chart is telling you, the accuracy is still limited since the conditions which produced the pattern in the past cannot be 100% completely replicated. In other words, the original traders that were involved with a stock 30 days ago when this pattern originally occurred are probably gone and new traders have come in anticipation of repeat performance. Will these new traders act in the same manner as the old?
Within the ranks of technical analysis there are two factions – chartists and technicians. While the chartist embraces a more visual approach to the analysis, the technician uses a more quantitative approach and often employs sophisticated statistical methods. Chartists refer to line studies such as trendlines, triangles, speed resistance lines, candlestick patterns, and the like. Technicians employ technical indicators which usually are variations of common statistical methods such as ordinary least-square regression, exponential moving averages, etc. Whereas fundamental analysis allows you to make an informed determination of a company’s current share valuation, technical analysis aims to improve the timing of your investments.
For example, until about five years ago, companies making televisions and computer monitors with the old-fashioned picture tube were likely to be profitable because with the introduction of personal computers in most homes, the demand for picture tube monitors was high. But anyone doing a technical analysis of the market for picture tube televisions and monitors five or so years ago would probably figure out that the picture tube was on its way out because no one wants a giant television or computer monitor when there is a slimmer, more attractive alternative.
Another factor in that market would have been the idea of radiation; the new alternative to the traditional picture tube did not fire electrons at a screen just in front of a person’s face. So, investing in picture tubes at that point in time would have been a poor choice even if at that moment the balance sheets showed long term past profit. In actuality, more data tends to be better than less data. So, considering both the thing itself as well as the characteristics of the potential market for the thing can help people to make wise choices in their investments.