Catching a real winner in the stock market just by doing some analysis may not be as tough as catching a fly with your bare hands. There are two tribes of analysts who know how to put their hands right on the spot even when the prices are moving up, down or sideways. One set of analysts attacks from the right by using what is called fundamental analysis, and the other set attacks from the left by using technical analysis. But sometimes both kinds of analysts may fail. You can catch a fly once, twice but not necessarily three times.
Johnny: Tell me first of all, what exactly is involved in fundamental and technical analysis?
Jinny: Before making any investment decision, all of us need some method of finding out the next success story. There are two most common methods of analysing securities—fundamental analysis and technical analysis. These two kinds of analyses greatly differ from one another. While fundamental analysts try to find the real long-term worth of securities by looking at financial information such as earnings, assets value and so on, technical analysts look at the past and present price movements along with volumes to discover the short-term market trend. Fundamental analysts use financial statements such as balance sheet, cash flow statement and income statement whereas technical analysts use charts as well as other technical indicators like MACD (moving average convergence-divergence), which can help in identifying a pattern in the price movements.
Johnny: What are the different assumptions behind technical and fundamental analyses?
Jinny: Technical analysts use three most basic assumptions. Their first assumption is that prices of securities reflect all known and unknown factors and hence a separate analysis for finding out their true worth is not necessary. Their second assumption is that prices are not random but follow a trend over a period of time and their third and more revolutionary assumption is that past trends in all probability repeat themselves. So the real art of the technical analyst lies in identifying the exact spot on a price chart where the prices are likely to either move up or down. Fundamental analysis on the other hand relies on different assumptions. First of all, fundamental analysts believe that it is really possible to find out the true worth of a security by carefully analysing all available financial information along with general macroeconomic conditions. Second, fundamental analysts believe that in the daily push and pull of the market, the prices of securities often get out of sync with the true value of securities. So the aim of fundamental analysis is to identify stocks that are either overvalued or undervalued. Fundamental analysts believe that in the long run, the market price of securities converge with their true value.
Johnny: It seems technical and fundamental analyses stand apart. Tell me Jinny, is there any common ground between them?
Jinny: Fundamental analysis can only work if you can patiently wait and watch the market for a couple of years, whereas technical analysis can work if you can take decisions in a day or hours or even seconds. It seems as if these two approaches are poles apart. But there is indeed common ground between the two. You can always use the insight of both the analyses together for making a more balanced decision. If a stock is undervalued as per fundamental analysis and at the same time undergoing downward momentum as per technical analysis, then it makes sense to wait before you buy. Tomorrow, you can buy the same undervalued stock at an even cheaper price. So, long-term investors can actually increase their gains by using technical analysis for timing their entry in the market. Short-term investors, on the other hand, can use fundamental analysis to see whether the short-term trends are due to some freak momentum or due to fundamental reasons. No doubt, the presence of fundamental analysis on their side puts the feet of technical analysts on a much firmer ground.
Illustration: Jayachandran / Mint
Johnny: It seems you can conquer the world if you have technical and fundamental analyses by your side.
Jinny: Most of the time you can be at the right place at the right time by using both fundamental and technical analyses together. But sometimes you may actually land at the wrong place. If conquering markets had been so easy, we would have never seen anybody lose. Sometimes freak moments are more powerful than your charts and earnings forecasts.
Johnny: Thanks for telling me all this. Sometimes you win sometimes you lose; life is full of red roses and moody blues.
What: Technical and fundamental analyses differ in their approach but both of them can serve as useful tool in making investment decisions.
How: Fundamental analysis relies on financial information like earnings and asset value whereas technical analysis uses price movements and volume.
Whom: Fundamental analysis suits long-term investors whereas technical analysis suits short-term investors.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org