Fundamental Analysis is the process of analysing stocks based on their fundamental attributes like earnings or book value. Technical Analysis is the process of analysing stocks based on their price history. The former is a widely accepted method of equity analysis while the latter is confined to a segment of the analyst community and has no scientific basis.
What is fundamental analysis
In fundamental analysis, an investor studies a company’s earnings, debt, reserves and various other financial metrics. Based on the value of the company’s assets and expected earnings, he arrives at a price for the company’s stock. If the prevailing market price is less than this value, he buys the stock and vice versa.
What is technical analysis
In technical analysis, an investor studies the price pattern of the stock as well the volume pattern of the stock. He draws inferences about the nature of the price pattern and decides whether to buy or sell the stock. For instance if the price is making higher highs and higher lows, he may decide to buy the stock. If the price has seen a sudden sharp decline, he may spot an enveloping candle pattern and sell the stock.
Why technical analysis is not credible
Technical analysis uses price patterns to forecast future prices. For example, it interprets a pattern of ‘higher highs and higher lows’ to forecast higher stock prices in the future. Alternatively, it uses other patterns such called ‘hanging man’ or ‘head and shoulders’ to forecast prices declines or increases. However these patterns have not been statistically tested and do not have a scientific basis.
Second, the patterns of technical analysis are highly subjective and open to interpretation. What one technician may seen as ‘hanging man’ or ‘dark clouds’, another technician may see as ‘hammer’ or ‘ head and shoulders.’
Technical analysis also disregards the ‘Efficient Market Hypothesis’, a widely accepted financial theory. The Efficient Market Hypothesis states that markets are efficient and hence all information having an impact on stock prices is immediately incorporated. Any pattern or trend in a stock is immediately seized upon by competitors and arbitraged away. Hence an investor cannot make profits from trading stocks based on their historical price patterns.