Fundamental vs. Technical Analysis: Pros & Cons, When and How to Use Each

Have you ever sat up all night long researching the stocks you wanted to purchase by going through annual reports, investor presentations, and going on company web sites only to find that the stock drops like a rock in the morning? What do you do at this point? Well, it depends on what your due diligence style is.

There are two main ways of analyzing stocks and they are through fundamental and technical analysis. Fundamental analysis is basically the ability to analyze a company’s financial strength and determine a decision based on value. Fundamental investors look for stocks that are below their intrinsic value. The due diligence involved requires investors to analyze a company’s financial statements, possibly talk with management or investor’s relations, keep track of earnings, and otherwise stay on top of the company. The objective in fundamental analysis is to make a projection on its future business performance.

Technical analysis, explained in the first article in this series, is quite different. This is the art of reading charts and deriving a decision to buy or sell solely on just that. There are no financial statements to read, no CEO’s to talk to, and no conference calls to listen in on. A chart is enough to make a decision. Technicians believe that past price patterns, trading action, and price-volume relationships, among other things, forms an accurate basis of where the stock is likely to move in the near-term. Since price patterns on a chart are formed by investors & traders past emotional responses to price movements, the patterns can be exploited for use in the future.

Out of the two, fundamental analysis is the more widespread discipline, by far. There is a lot of criticism concerning technical analysis with some calling it “black magic”, or suspicious, or irrelevant. This is simply not true. Many critics are academics who have never traded a single stock in their lives. Most of these critics have never used technical analysis. A lot of this criticism comes from the Efficient Market Theory which states that the market’s current price is accurate and correct and that past information (same as charts) is already discounted into the stock. There are variations of this theory; however, most of these people believe that if technical analysis works then market efficiency may be questionable. Obviously, this is not true since the market is efficient.

Does all of this mean that one is better than the other? No! I believe that it is not only important to master technical analysis, but you must also be aware of a company’s financial strength as well. Because the stock market sometimes moves in an irrational manner, sometimes charts will not accurately represent the company’s value. In addition, technical analysis must be relied on because sometimes financial statements and management “misstate the truth”. Knowing how to perform both fundamental and technical due diligence is critical for both investors and traders.

Are there times where one is more effective than the other? Yes! It all depends on 1) your time horizon, 2) personality and type. Below is a chart that plots the effectiveness or ineffectiveness of both types of analyses as the time horizon shifts from short-term to long-term. In my opinion, technical analysis is most effective in the short-term and less effective in the long-term, and fundamental analysis is most effective in the long-term and less effective in the short-term. The ability to perform both analyses gives investors and traders flexibility throughout each timeframe.

Short-term is defined as micro-trading (minutes), day trading (hours), and swing trading (days). Intermediate-term is defined as any holding period between several months up to a year and long-term is defined as 1+ years.

I mention personality type as a determinant in which style to choose from because I believe that each person has a greater strength in one other the other. For me, it is technical analysis because I’m not very good with numbers, nor do I have the time to sit down and read through a 50-page report. I am also a visual person that appreciates shapes and figures. I am also a short-term oriented trader, unable to stand waiting for years holding a particular stock. This is why technical analysis benefits me the most and the reason why I enjoy it the most.

My personal belief is that the chart shows everything you need to know. I also believe that most, if not all, fundamental analysis is already priced into a stock. I know that the many patterns that do form (which I will cover in future articles) have formed since the birth of the chart and are formed from human nature, which by the way, will never change. Just because someone on TV says something fundamental that sounds really smart, it doesn’t mean that the stock is a buy right now. The chart confirms fundamental decisions.

What does your timeframe and personality indicate your strength is? Once you determine that, we are ready to move forward.