When you are interested in investing or index trading, one of many questions you must answer is whether you are interested in fundamental or technical analysis as your trading strategy. These are the two main philosophies used by investors, and each trading strategy has its unique characteristics and merits. The current state of the major markets, as well as your personal financial goals, will end up dictating what strategy you will choose.
Technical analysis is a system that tries to predict the price movements of a stock based solely on its previously observed patterns. In contrast, fundamental analysis focuses on the fundamentals, which are economic factors directly affecting the company, when making trading decisions.
A Closer Look at Fundamental Analysis
Fundamental analysis looks closely at a business, analyzing its cash flow statement, income statement, and other financial records to determine the intrinsic value for that particular company. When the stock price is below this supposed intrinsic value, the asset is considered a good buy. A stock is considered a poor investment if the purchase price is greater than its intrinsic value. Of course, there are many other economic factors considered by the fundamental analysis trading strategy, but this gives a basic idea of how the analysis works.
With fundamental analysis, investors must analyze the market and the company over the long term. Most fundamental analysts want many years’ worth of information from the companies they are considering investing with in order to make a decision. Also, the investments are considered long-term investments, as it takes a while for the company’s actual value in the market to reach its intrinsic value as stated by the analyst. In a down economy, this can translate into lost income, because the investor must buy and hold the asset for many years without seeing any increase in value. The investor is assuming that the increase will come later and that the stock will eventually have the same value as the company’s intrinsic value.
Fundamental analysis has a longer history of use by investors. This has been a tried and true investing method for years. Conventional financial wisdom holds it to be the safest method of investment. However, in order to succeed in long-term investing using fundamental analysis, you must have a thorough understanding of economics, the resources necessary to find the economic statistics about a particular company, and a sound company in which to invest. Many have lost money in recent years when companies that appeared to be sound on paper suddenly went bankrupt. In the long term, some losses like this may not affect an overall investment plan, but for many seeing them is discouraging in the short term. This has led to a growth in the popularity of technical analysis and index trading.
A Closer Look at Technical Analysis
Those who are interested in swing trading often take the technical analysis approach. This involves analyzing the stock alone and not focusing on the economic factors affecting the company. An investor using technical analysis is unconcerned with the underlying value of the business, as perception of a stock’s value can often influence its price more than the underlying performance of the company. Index traders using a technical approach find everything they need to know in the price and volume movement of a security’s chart.
As such, the technical analysis approach is a more short-term investing style. The goal is not to buy an investment and hold on to it for a long time, but rather to buy an asset when it has a low price and sell it as soon as it has gained enough to make the trade worthwhile. These investors are constantly making trades back and forth, which is why this type of trading is often called swing trading. The charts they use are also short-term in scope. They may cover a few days or a few hours, depending on the type of trading being done, but they rarely cover several years. Active index traders try to determine the likely short term price action of a stock, in order to position themselves favorably for future market conditions.
Technical analysis often produces outsized returns in the short term, as compared to fundamental analysis methods. Traders using technical analysis need a reliable trading strategy in order to cement their gains over the long term.
Technical analysis and trading often perform very well when the the market as a whole is performing poorly. When markets as a whole hold steady or drop, there will always be days when a particular stock will do very well, and others when it will do very poorly. Index trading allows the investor to analyze past trends and predict when these spikes and drops will occur. This means that the investor can sell when the price jumps up and buy when the price goes down, creating a return even in a time when buy and hold investors are not seeing any. When trades are done well, nearly every movement in the market earns a return, even if it is just a small one. Investors relying on fundamental analysis are hoping to see a return based on the predicted performance of a company. If that company’s product or service stops selling well, the investor will lose significant amounts of money.
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It is up to you to look at your financial needs and goals and decide which method of trading you are going to use. Are you looking for a long-term investment option, or do you want a short-term option to get you through the current economic downturn without significant losses? Do you need to see an increase in your investment soon for an upcoming expense, or do you have the luxury of time to wait for future increases? A mixed approach utilizing both methods of trading may help balance your portfolio and meet your financial and risk management goals. Regardless, understanding both schools of thought and how they play out in an economic downturn is crucial to your investing success.
