Stock market is one of the best places to invest money as it is capable of giving investors inflation-beating returns in all investment time horizons. However, whether you are a stock market trader or investor, you need to have at least a basic understanding of how the stock market works in order to make money.
It is not possible to time the market, but you can always analyse it and keep your investments profitable. There are 2 ways of analysing the stock market – Fundamental Analysis and Technical Analysis.
What is Fundamental Analysis?
Fundamental analysis refers to studying the basic fundamentals of a company in order to understand how its shares will perform or are capable of performing in the future. It aims at evaluating the true value of a stock on the basis of its fundamental attributes. It involves studying a company’s earnings, debt, reserves, assets, liabilities and various other financial metrics. It also takes into account the health of the country’s economy and industry conditions in order to get a holistic view of the company’s position.
After such an analysis, it is possible to arrive at an appropriate price for the company’s stock. If the prevailing market price is less than this value, then the stock is determined to be undervalued and a good bet for buying which has the potential of giving good returns in the near future. Similarly, if the market value of a stock is more than this price, it is considered as overvalued and a good investment for taking sell positions.
What is Technical Analysis?
Technical analysis refers to the approach which aims to predict the future behaviour of a stock on the basis of its past or historic performance. In technical analysis, an investor studies the price pattern of the stock as well the volume pattern of the stock. The analysis is aimed at drawing inferences about the nature of the price pattern and deciding whether to buy or sell the stock. For instance, if the price is making higher highs and lower lows i.e. high volatility, an investor may decide to buy the stock to benefit from this volatile stock movement. Similarly, if the price has seen a sudden sharp decline, he/she may spot an enveloping candle pattern and sell the stock at the correct time.
Thus, we can conclude that while the fundamental analysis is scientific in nature, the technical analysis is a subjective approach.
Fundamental Analysis VS Technical Analysis
While fundamental analysis aims at understanding the basic attributes of a stock, technical analysis studies its past performance to predict its future pattern of behaviour. The decision to follow rests with the investor depending which approach he/she finds more accurate in analysing the stock market. However, the following are the limitations which can be attributed to technical analysis approach.
- Use of Non-Statistically Tested Behaviour Patterns: Technical analysis involves studying past performance patterns of stocks such as ‘higher highs and higher lows’ to forecast stock price highs and lows in the future or ‘hanging man’ or ‘head and shoulders’ to forecast price declines or increases. However, these patterns have not been statistically tested and according to many analysts these do not have a scientific basis.
- Subjective Interpretation: 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.’ Thus, the same pattern can be interpreted in different manners by different technicians thereby bringing in subjectivity.
- It Disregards Efficient Market Hypothesis: 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.
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