When it comes to investing in the stock market, different investors follow different approaches.
Fundamental analysis and technical analysis: investing strategies that are poles apart
Fundamental analysis and technical analysis are two entirely different approaches used by investors in the stock market. Fundamental analysis works best for long-term investment and is a time-tested strategy to create sustainable wealth, whereas technical analysis is preferred by traders looking to make quick gains through short-term investing.
Praveen and Sagar are colleagues who started their stock market investment journey together in the year 2011.
Praveen is a long-term investor in the stock market who uses fundamental analysis to evaluate stocks before investing. He is a patient investor and an avid reader of books on value investing and strongly believes that fundamental analysis is the best way to invest in the stock market.
As a result, Praveen managed to identify and invest early in many potential mutlibaggers which turned his initial investment of 3 lacs into 30 lakh rupees over a period of 10 years.
On the other hand, his colleague Sagar believes in short-term investing and uses technical analysis. He too had started off his investment in the stock market with an investment of 3 lakh rupees but after 10 years in the stock market, the total value of his investment is still around 3 lakh rupees. While Sagar did make some gains initially, his early gains were quickly wiped out due to recurring losses. To make matters worse, high brokerage charges due to frequent buying and selling had also reduced his profits considerably.
The objective of both fundamental analysis and technical analysis is to research and forecast future trends in stock prices, and both these methods of analysis have their own advantages and disadvantages.
To help understand which method is best for investment in the stock market, let’s take a detailed look at both.
Fundamental analysis is a method of assessing securities by measuring the intrinsic value of a stock. It involves the study of the financial condition of a company, its management, the overall economy, and the sector in which it is operating. The most commonly used data used in fundamental analysis includes cash flow, earnings, expenses, earnings per share, profits, assets, liabilities, debt, dividends, and estimated growth in the rate of earnings.
Fundamental analysis is used for determining the real or fair market value of a stock. If the real value of the stock is higher than the market price, the stock is deemed to be undervalued and hence offers a good value proposition.
On the other hand, technical analysis focuses studying the historical price trends of the stock.
In technical analysis, no attempt is made to measure a stock\’s intrinsic value. Rather the focus is on stock charts to identify patterns and trends which suggest the future movements of a stock price. In technical analysis, the main parameters considered are the stock\’s price and volume. Some of the most popular forms of technical analysis are support and resistance, trend lines, and simple moving averages.
Let’s take a look at the advantages and disadvantages of fundamental analysis and technical analysis
Advantages of fundamental analysis
Fundamental analysis is an effective strategy for identifying and investing in stocks that represent a good value while investing for the long term to achieve capital appreciation.
One of the greatest benefits of fundamental analysis is that an investor develops a strong understanding of the business and industry due to the detailed and extensive research and analysis involved.
Disadvantages of fundamental analysis
The real or fair value of a stock is based on assumptions. Sudden or unexpected changes in the fundamentals of the stock can significantly alter the results of the analysis.
Fundamental analysis can help one in identifying an undervalued company but it does not indicate the right time to invest in a stock. In simple words, even if an investor does manage to find a stock which is trading below its intrinsic value, and it may continue to remain at those level for a considerable amount of time before meeting the investor’s expectations for near-term growth.
Advantages of technical analysis
Fundamental analysis and technical analysis require considerable data. Here technical analysis scores over fundamental analysis as the amount of data required is considerably less.
While using technical analysis, it is easier for investors to time the entries and exits for trades as it is mostly focused on identifying new trends and reversals in trends.
Disadvantages of technical analysis
The drawbacks of technical analysis include mixed signals, where two different indicators may indicate contradictory information. While one indicator could indicate a buy, the other could indicate a sell leading to confusion. Many times, technical signals generated may suffer from a time lag, leaving the trader confused, and by the time the trader gets a clear signal the price action could already be over.
Technical analysis may not be able to accurately predict future trends every time, due to high volatility in the market. As a result, an investor can never generate consistent returns with technical analysis to build sustainable wealth.
Fundamental analysis is one of the best and time-tested ways for wealth creation through investment in the stock market. While the technical analysis may help, traders to place some winning trades in the short term, it is not enough to create sustainable wealth due to the high market volatility in short term. On the other hand, fundamental analysis helps an investor to invest in quality businesses that will outperform in the long run, thereby creating wealth for investors.
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