Introduction
The two major approaches used to predict the prices of stocks or currencies include fundamental analysis and technical analysis (Malkiel 119). Fundamental analysis focuses on different aspects of a stock’s performance, such political environment, company performance, inflation, and economic forces. On the other hand, technical analysis focuses on a stock’s past prices in order to determine probable patterns in future price fluctuations (Malkiel 119).
In the financial field, the validity and efficacy of the two methods are important aspects of discussions among traders and financial analysts. Research has revealed that fundamental analysis is highly efficacious with regard to predicting long-term trends while technical analysis is more suitable for predicting short-term price trends. In many financial markets, both methods of analysis are used together for higher accuracy in price prediction. When both methods are used together, the predicted price of a stock is more accurate than the value computed from either of the methods.
Technical analysis
As mentioned earlier, technical analysis utilizes past performances of stocks to predict future trends (Malkiel 119). Information collected from past price patterns is used to draw charts, develop strategies, determine market turnarounds, and identify opportunities for buying or selling stocks at any given time. Technical analysis is more efficacious when used to predict short term price fluctuations. Technical analysis involves using past stock prices and volume data to identify trends that are then used to predict future prices (Malkiel 119). Traders use a wide array of indicators that include regressions, moving averages, relative strength indexes, and support/resistance levels.
These indicators are used to identify possible trends followed by stock prices. A trend can go upwards, downwards, or sideways depending on prevailing economic conditions. Therefore, a market trend is the major concern of technical analysis. A market trend offers invaluable information regarding the direction of a financial market. This method is widely used because stock prices move in patterns that are easily recognized. Technical analysis is considered as a superficial method of trading because it collects data from past performances only. It does not utilize information from sources such as company portfolios, currency fluctuations, and market trends.
Technical analysis functions on the principle that a stock’s price is indicative of the collective market forces that determine stock prices (Malkiel 120). Therefore, economic and market forces are reflected in the price of a certain stock. In addition, this principle assumes that price action is repetitive because investors follow certain trade patterns that create definite and identifiable market trends. The basic theories that underlie technical analysis include Dow, Fibonacci retracement, and Elliot wave theories. Wall Street is famous for technical analysis that involves short-term investing for quick returns.
Fundamental analysis
Fundamental analysis utilizes information from macroeconomic indicators, financial markets, political environment, economic forces, and other aspects such as inflation and unemployment rates (Malkiel 129). Unlike technical analysts, fundamental analysts believe that it takes time for a stock price to respond to external forces and therefore reflect its correct intrinsic value. This method is more efficacious when used for long –term investments. An example of fundamental analysis is value investing. Value investing involves looking for stocks that possess high intrinsic values when compared to their current market prices (Malkiel 129).
Fundamental analysis focuses mainly on computing the intrinsic values of stocks. Fundamental analysts study the performance of companies, their financial reports, and projected growth patterns (Malkiel 130). This information is then used to determine whether the price of a stock reflects all this information regarding the parent company. In addition, analysts study the assets, liabilities, and operating balance of a company before determining the value of its stock.
Future revenues and stock dividends are also considered (Malkiel 129). Examples of theories used in fundamental analysis include purchasing power parity, interest rate parity, balance of payments model, and asset market model theories. Investors get information from three areas namely economic analysis, industry analysis, and company analysis. Information collected from the aforementioned areas of analysis is used to determine the intrinsic value of a stock.
An investor buys a stock if the computed stock value is higher than the current market price of the stock. In the contrary, if the computed value is less that the current market price, the stock is avoided because of overpricing. Fundamental analysis fails if the information collected regarding a company is false, the computed intrinsic value of a stock is wrong, and the price of a stock might not rise to a predicted value (Malkiel 132).
Conclusion
Technical analysis and fundamental analysis are used to predict prices of stocks in financial markets. They follow different approaches. Technical analysis uses past stock price patterns and volumes data to predict future prices. In contrast, fundamental analysis utilizes macroeconomic indicators, financial market performance, economic forces, and other aspects such as inflation and unemployment rates to predict stock prices. Technical analysis is efficacious for short-term trading while fundamental analysis is efficacious in long-term trading. An example of the application of fundamental analysis is value investing. In value investing, investors look for stocks that possess high intrinsic values when compared to their current market prices.
Works Cited
Malkiel, Burton. A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing. New York: W. W. Norton & Company, 1999. Print.