Fundamental Analysis is the process of analysing stocks based on their fundamental attributes like earnings per share (EPS) or book value (BV). Technical Analysis is different as it is the process of analysing stocks based on their historical prices. Thus the key difference between fundamental and technical analysis is that while the former is a widely accepted method of equity analysis for investors, the latter is mainly confined for use by a small segment of the analyst community and often ignored by investors at large.
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, it is possible to arrives at an appropriate price for the company’s stock. If the prevailing market price is less than this value, the stock is determined to be undervalued with the potential to give high future returns. The opposite typically holds true for stocks that are determined to be overvalued through use of fundamental analysis.
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 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 may spot an enveloping candle pattern and sell the stock at the correct time. This is by far the most critical difference between fundamental and technical analysis – one is highly scientific (fundamental analysis), the other is very subjective (technical analysis).
Limitations of Technical Analysis
By its definition, technical analysis uses price patterns to forecast future prices. For example, it interprets a pattern of ‘higher highs and higher lows’ to forecast stock price highs and lows 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 according to many analysts these 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.