This article will focus on the decision making process for investing. There will be a special emphasis on comparing and contrasting fundamental and technical financial analysis. The success of the financial market is important to everyone across the world. If the market is not healthy, there is potential for crises. It has been suggested that most Americans do not know how to save or prepare for their future. As a result, many financial investment companies have approached employers as well as individuals in an attempt to educate the masses on the benefits of investing. When one is analyzing the financial market, he/she has the option of using one of two approaches. Fundamental and technical analyses are two types of analysis, but they have different approaches in terms of whether or not to trade or invest in financial markets.
Keywords Capital Asset Pricing Model (CAPM); Compounding; Day Trading; Financial Markets; Fundamental Analysis; Investments; Stock Market; Technical Analysis; Trading
Finance: Fundamental vs. Technical Financial Analysis
The success of the financial market is important to everyone across the world. "We live in a world that is shaped by financial markets and we are profoundly affected by their operation. Our employment prospects, our financial security, our pensions, the stability of political systems and nature of the society we live in are all greatly influenced by the operations of these markets" (Fenton-O'Creevy, Nicholson, Soane, & Willman, 2005, p. 1-2). If the market is not healthy, there is potential for crises.
It has been suggested that most Americans do not know how to save or prepare for their future. As a result, many financial investment companies have approached employers as well as individuals in an attempt to educate the masses on the benefits of investing. Some of the tips that have been provided by organizations, such as the American Association of Individual Investors, include:
- Build and maintain a cash reserve to meet short-term emergencies and other liquidity needs.
- Develop an overall investment strategy even if it cannot be implemented immediately.
- Select mutual funds that fit into the overall investment strategy, then consider what the minimum initial investments are.
- Select a balanced fund for less aggressive investors or a broad base index fund for more aggressive investors. Build the portfolio after this initial investment has been completed.
- Review the percentage commitment to each stock market segment in order to determine when to add funds to the initial investment.
- Do not agonize over small deviations from the original allocation plan. Stay the course! (p. 1-2).
When one is analyzing the financial market, he/she has the option of using one of two approaches. Fundamental and technical analyses are two types of analysis, but they have different approaches in terms of whether or not to trade or invest in financial markets. Overall, the process focuses on how to select markets and tools in order to trade or invest and time when it is appropriate to open and close trades or investments in order to maximize returns.
Definitions: Technical Analysis vs. Fundamental Analysis
According to investorwords.com, technical analysis is defined as:
A method in which to evaluate securities by relying on the assumption that market data (i.e. charts of price, volume, and open interest) may assist in predicting future (usually short-term) market trends. Unlike fundamental analysis, the intrinsic value of the security is not considered. Technical analysts believe that they can accurately predict the future price of a stock by looking at its historical prices and other trading variables. Technical analysis makes the assumption that market psychology influences trading in a manner that allows an analyst to predict when a stock will rise or fall. For that reason, many technical analysts are also market timers. Market timers believe that technical analysis can be applied just as easily to the market as a whole as to an individual stock.
According to Investopedia.com, fundamental analysis is defined as:
A method in which to evaluate a security by attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors. Fundamental analysts study those things that may affect the security's value, including macroeconomic factors (i.e. the overall economy and industry conditions) and individually specific factors (i.e. financial condition and management of companies). For example, the goal of fundamental analysis is to identify a value that an investor can compare with the security's current price with the expectation of determining what position to take with that specific security.
Choosing an Approach
Which is better? Both types of analysts have been successful in the designated fields. Many studies have been undertaken to determine which approach is better and to delineate the merits of each approach (Kaouther, 2013). The "right" answer depends on what the investor is interested in. For example a long-term investor looking for companies with a solid base, growth and income potential may be interested in the fundamental approach. However, there have been scenarios where a long term investor was not concerned about one company's basics because of plans to diversify in order to minimize risk or a short term investor waiting for investor sentiment to change. These types of investors would probably support the technical approach. Given the strengths of both approaches, many investors tend to find benefits from each type of analysis. Technical analysts can provide information on the broad market and its trends (macro level) but do not take into consideration the context of current economic and world events which some consider to be a weakness of this approach (Field, 2013). Fundamental analysts, however, can assist an investor in determining whether or not an issue has the basics in order to meet the investor's needs (micro level). In order to get a glimpse of the "big picture," it may be beneficial to take the best from both approaches.
The question of which approach is better will probably never be answered given the explanation listed above. Also, "there is little agreement on the supremacy of one approach because the success of a trader's system is so dependent on the individual characteristics of each trader" (Talati, 2002, p. 58). Let's explore the characteristics of both approaches.
Capital Asset Pricing Model (CAPM)
In order to select investments for a portfolio, modern portfolio theory will use the capital asset pricing model ("What is modern…," 2007). The capital asset pricing model (CAPM) is utilized to calculate a theoretical price for a potential investment, and is a linear relationship between the returns of the shares and the stock market returns over time. The model analyzes the risk and return trade-off of...
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