Let’s discuss the pro and cons of technical vs fundamental analysis. I’ll list the arguments made in the book Technical Analysis of the Financial Markets and add my own thoughts. Quotations from the book are marked in italics.
What is technical analysis?
Technical analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends.
There are three premises on which the technical approach is based:
- Market action is reflected in the price.
- Prices move in trends.
- History repeats itself.
Market action is reflected in the price charts
Technical analysis is based on the premise that everything that happens in the market, whether fundamentally, psychologically or otherwise, affects the market price. The reasoning of technical analysis, therefore, goes that if the study of price action is all that is required.
I totally agree that many things affect the market price, and often within minutes. There are many examples of tweets which affect the stock price for instance. The charts simply reflect the bullish or bearish psychology of the marketplace. Chartists (technicians) don’t concern themselves with the reasons why prices rise or fall. Often no one seems to know the reason in the early stages of a new price trend.
Prices move in trends
Another premise of technical analysis is that prices move in trends. An upward trend means that prices rise, a downward trend that they fall. The technician, therefore, tries to take advantage of those trends by buying when the price is low and selling when the top of an upward trend is reached.
History repeats itself
The study of chart patterns reveals certain patterns which reveal psychological traits. Since these patterns have worked in the past, it is assumed that they will continue to work in the future since human psychology does not change rapidly (history repeats itself).
But does the fact that everything is reflected in the charts justify the premise that the study of the market price is all that is necessary? My answer is it depends on what you want. Do you want to trade? Then probably your focus will be on market trends. Do you want to invest long-term like I prefer to do? Then you should do fundamental analysis.
Fundamental analysis
While technical analysis studies the market action, fundamental analysis focuses directly on the economic forces of supply and demand. Analyzing all the relevant factors affecting the price of a market in order to determine the intrinsic value of that market. The intrinsic value simply means what the business is worth based on supply and demand. When the business’s market value is less than its intrinsic value, then it is underpriced and should be bought. If it’s value is higher then it should be sold.
In summary: The fundamentalist studies the cause of a market movement while the technician studies the effect.
So which approach is better? None, an ideal approach will consist of an overlap of both methods. But as a general rule, use technical analysis for short-term trading, and fundamental analysis for long-term investment.
In the book, John argues that technical analysis is superior because it includes the fundamental analysis, while fundamental analysis does not include technical analysis. In other words, a technician notices fundamental changes in his charts, whether or not he actually knows why they happen, he can react to them. While a fundamentalist often can’t tell why the market is doing a certain move just by looking at his fundamentals. So is chart reading a shortcut to fundamentals after all? No, and let me tell you why.
Which approach is better?
Let me explain why, at least for long-term investing, the fundamental approach is better. The best investors on earth, Warren Buffet and Charlie Munger do not pay attention to the market. They consistently outperform the market by a huge margin, 24% compounded annually vs 11% from S&P. In Charlie Munger’s words: “We’re predicting how people will swim against the current. We’re not predicting the current itself.” Warren and Charlie, of course, are investors not traders.
They carefully analyze the value of a business they are interested in, not paying attention to current market trends. Why? Warren puts it this way, if he had listened to his dad who told him that it was not a good time to get into the security business, he would still have the 10,000$ he started with.
Another argument against technical analysis is false precision in charts. Buffet claims that investment managers make things more complicated than they are and Munger adds that the worst mistakes are made from the nicest graphs and that what is really needed is enlightened common sense. They act on the principle: “I would rather be vaguely right than precisely wrong”.
Examples from my own experience
I started playing with cryptocurrencies about 6 months ago. I managed to make some good money with trading initially but then learned the hard way, losing about the same amount I had initially made. This experience thought me several lessons.
- Trading consumes a huge amount of time. You have to spend every day analyzing trends and making sure to sell at the right moment. Even if you can make use of automatic sell and buy triggers, you still will have to invest some time.
- It is much riskier to trade than to just invest in a currency you can be sure which will get more value over time.
I applied what I learned when IOTA had it’s IPO. After analyzing it in detail, I realized the tremendous potential of this new technology and sold all my other currencies in exchange for IOTA. I will go into more detail about my analysis in another post. Just know that I’ve gotten very good results. The value of my portfolio increased by 10x and I expect another increase of more than 10x next year.
But here is the decisive point, I couldn’t have predicted the success of IOTA by the charts. As it even had a downward trend for several months.