Hope you guys are having a fun festival season!
I love this time of the year. Business generally slows down, and friends, family and in general happiness takes a front seat.
Besides, if, by any chance, you aren’t having a good time, take a deep breath, and believe in yourself. Believe in the people around you. Keep grinding my friend. Turnaround is just around the corner.
As mentioned in the last post, I planned to cover different trends in the market in this one. However, as I went about preparing for it, I realized there wouldn’t be any point in getting into trends without framing a ‘why’ around it.
Hence, this post is going to touch upon what is Fundamental Analysis, Technical Analysis, and the difference between them.
Below is a list of resources I have referred to for this blog:
- “Technical Analysis of the Financial Markets”, a book by John J Murphy. It is one of the classics in the field, recommended by many tenured market experts. I came across this after joining one of the best forums for traders to learn called “TFS – Train for Success”, where a bunch of extremely good people, guided by Nishant Arora and TFS Faisal, help out aspiring traders.
- Good old Investopedia, which has more than a few articles on the topic
- A YouTube video on the channel UKspreadBetting, where a technical trader and analyst named Francis Hunt who is also the owner of “The Market Sniper” is interviewed
So What is What!
Fundamental Analysis (FA)
In simple words, FA focuses on finding the actual value of a stock.
For example, if the current market price of a stock is INR 100, a fundamental analyst will evaluate factors like the overall economy, the financial condition of the company, assets, debts, promoter profiles, areas of business, etc. to find if the stock is worth INR 100.
If the actual worth of the stock is under INR 100, let’s say INR 50, the investor will either not buy the particular stock or sell it off if they are currently holding it. If it is over INR 100, let’s say INR 150, the investor will buy and accumulate the stock so that he can sell and make a profit when the stock reaches there.
To arrive at the actual intrinsic value, an investor adopts several methods such as Discounted Cash Flow, Qualitative Analysis, and Value Investing, etc. Most of these methods include analysis of company data through financial statements like annual reports to calculate parameters which will help in decision making.
Warren Buffet is probably the poster boy of a fundamental investor in the modern era.
“Only buy something that you would be perfectly happy to hold if the market shut down for 10 years”, – Warren Buffett
His quote aptly conveys the mindset an investor must have while engaging in investing based on FA.
The most important thing with fundamental investing is that no one can predict when the journey to a stock’s actual intrinsic value will happen!
It might take a few months or years or even decades. The price might also go down first before taking off, which in essence means that FA doesn’t come with an apt entry or exit point. It makes it extremely difficult to quantify risk in case of an error in analysis.
Hence, someone keen on engaging in FA should focus on wealth creation than income generation. That said, it is also a fact that people who have made millions out of the market are dominated by fundamental investors, who picked up a promising script before majority noticed and persisted with it for a more extended period.
Technical Analysis (TA)
TA, on the other hand, is the study of how a stock behaves according to its demand and supply.
At any point in time, the stock market is a tug of war between a buyer and a seller or between bulls and bears. Sometimes buyers get the upper hand, and sometimes sellers get the upper hand and depending on who is over whom, price increases or decreases.
A technical analyst stays in the present and uses price and volume charts or statistics to forecast the next move based on the tug of war and takes a trade depending on that. Their objective is predominantly income creation, though, over time, it can end up turning into massive wealth.
As per the book “Technical Analysis of the Stock Market”, a technical analyst believes in three primary assumptions:
- Market action discounts everything
- Price moves in trends
- History repeats itself
Market Action Discounts Everything!
It means that, when analysts study market charts, they are indirectly studying the impact of fundamentals without necessarily giving a hoot about what the fundamentals are.
Quoting from the book, “A technician believes that anything that can affect the price – fundamentally, politically, psychologically, or otherwise is reflected in the price of that market.”
So they assume that when demand for a stock increases its supply, the price will rise, and when the supply for a stock rises the available demand, the price of the stock will fall.
Price Moves in Trends!
The market tends to move in a trend, and a trend tends to continue until the point there is a force strong enough to slow, stop, and reverse it. As mentioned in the previous point, why the trend reverses is irrelevant for a technical analyst. They are only concerned with riding it till reversal. As mentioned in the introduction, we will dwell deeper into different aspects of trends in our next post.
History Repeats Itself!
People who have studied technical charts of different scripts for years and years have identified specific patterns and reactions to repeat again and again and again. It is predominantly because buyers and sellers in the market are humans guided by two emotions – fear and greed.
The normal reactions based on these emotions of a group of people tend not to change. Hence there are strategies like candle patterns, support & resistance, pivot points, Fibonacci retracement, Bollinger bands, moving averages, etc. which depend on repetitive actions from the players in the market.
However, reading emotions is not always straightforward. There is an element of uncertainty, which technical traders have to insure themselves against by timing entry and exit points correctly.
Most common misconception!
The most common misconception that goes around in the trading realm about FA and TA is that FA is for long-term and TA is for short-term.
However rare the chances are, it is quite possible to combine FA with industry or company specific event to take position expecting a short-term zoom in a share price. Similarly, it is possible for a technical trader to use charts of a longer time frame to make a trade for a more extended period.
Risks are a bit high in case of longer TA led trades since a chart based on which we take a technical entry doesn’t take into consideration a future event. That is where risk management and techniques, such as stop-loss are employed.
So which method is better?
It is a highly debatable question. The fact is that neither of the methods is superior to each other. Both are different versions of each other, and both have their pros and cons.
They are two different routes to arrive at an answer to the same question. However, then, it is almost always noticeable that stocks that have great charts will have great fundamentals and stocks that have poor charts will have weak fundamentals.
For any individual, deciding on which route to take will depend upon a lot of factors such as:
- A traders personality type
- Money and time at disposal
- Risk appetite
- Knowledge, ability, and aptitude in terms of reading charts versus understanding and comprehending financial information
There are multiple online checklists like this one to evaluate your orientation. There are many folks who use a combined approach whereby they select a stock based on the fundamentals but time their entry and exit using technical. Although this sounds great as a concept, there is a chance of bigger screwup if not done right.
What one needs to understand and accept is that is not always an easy decision. It needs quality deliberation.
Who am I?
As mentioned in my earlier posts, I am inclined towards the technical side of things since I have found myself enjoying chart analysis more than the financials.
It gives me immense satisfaction when I go with a hypothesis based on my chart analysis, and it heads in the direction my analysis suggested.
So, to begin with, Technical Analysis is my poison. As I evolve, this may or may not change, which is a discussion we will keep aside for another day.
Merry Christmas Everyone! Have a great time with your family.
Till next time, Cheers