When it comes to analyzing individual securities there are two main methods: fundamental and technical analysis. If you are thinking about investing on your own, or are in the process of studying for any of the CFA exams, knowing the difference between these two schools of thought is imperative.
If you were to analyze a financial instrument using fundamental analysis, the main goal is to determine its intrinsic value, or the value an investor thinks the asset is actually worth. Fundamental analysts study anything that can affect the security’s value to estimate the intrinsic value, including the overall economy, future cash flows the asset will pay out to the investor (such as dividends), the company’s financial statements and ratios, the management of the company, as well as industry conditions. The analyst will then compare the intrinsic value with what the asset is currently trading for, and determine if the asset is over priced (intrinsic value is less than the market value), fairly priced (intrinsic value is roughly equal to the market price), or under priced (intrinsic value is greater than the market price).
It is then up to the individual investor to decide how to take advantage of this inefficiency. If the stock is under priced, shares can be purchased hoping that the market price will eventually increase to the intrinsic value. However, because it usually takes a long time for the market to accurately reflect an asset’s intrinsic value, investors using fundamental analysis are usually trying to make long-term investments. If the shares are over priced, the investor could close their position in the asset, thinking that the market price will correct to the intrinsic value. (Futures and options can also be used to profit from mispriced stock.)
If an analyst was to use technical analysis instead of fundamental analysis, they would evaluate a security’s future price movements by looking at the stock’s historical and current price and volume data. In its most basic form, technical analysis is the study of investor psychology/sentiment which is measured by charts that represent changes in price and volume. Some of the most common graphs include:
- Line Chart – a plot of data points, such as share price, connected with a line that shows movement over time.
- Bar Chart – a graph showing four points of data for each entry, including the open and close price, as well as the high and low points.
- Candlestick Chart – includes four data points (high, low, open, close) which make it very similar to a bar chart, but the color of the entry represents if the price is moving up or down.
- Point and Figure Chart – a chart consisting of X’s and O’s which represent the change in a security’s price, a specific time period is not referenced.
Technical analysts also use several indicators that help predict price and volume movements, three common ones being:
- Moving Average – the average of a stocks closing price over a specified number of periods which smooth out short time price fluctuations allowing an analyst to get a clearer image of a market trend.
- Bollinger Bands – a moving average that has an upper and lower limit which is a set number of standard deviations from the security’s average price.
- Relative Strength Index – a graphical comparison of a security’s gains with its losses over a set period, calculated as the ratio of two security prices over time.
As opposed to investors using fundamental analysis, those using technical analysis are usually trying to identify opportunities to make a profit in the short-term.
Fundamental and technical analysis cannot be more different. Where fundamental analysts look at every detail about a company, technical analysts don’t even need to know the name or type of security, as long as they have a chart of price and volume data they can try to determine a trend.