Comparing Technical and Fundamental Analysis
Throughout each CFA level (but mostly tested in L1) you could come across questions asking you to compare/contrast trading strategies built using technical analysis versus those that depend on fundamental analysis.
Let's start by defining both before highlighting the key differences between these two very different frameworks.
Defining Technical Analysis
Technical analysis is a method of analyzing past trend data on securities or markets in order to predict or forecast future prices. The analysis often centers on price and volume trends.
Proponents of technical analysis believe that the chart of a securities price over time conveys a real-time snapshot of supply and demand and hence encapsulates the sum of necessary information needed in order to predict future prices.
Put differently, since price and volume represent the collective action of all the buyers and sellers in a market, studying the patterns of this dynamic via charts can tell you everything you need to know about the market—no time consuming fundamental analysis required. This is why technicians are often called chartists.
One implication of this is that technical analysis does not believe that the efficient market hypothesis holds (recall that if markets are efficient there should be no risk-adjusted returns possible from trading on publically available information).
In order for technical analysis to “work” a few assumptions need to be true. These assumptions all center on the belief that the market efficiently reflects the collective knowledge, sentiment, and behavior of all its participants.
Defining Fundamental Analysis
Fundamental analysis attempts to determine an asset’s intrinsic value, often by discounting its future cash flows (remember NPV?) using information from a firm’s financial statements.
So when you're trading using one or the other, how are they different?
- Does not require detailed information about the security
- Less time-consuming, often favored by short-term traders
- Assumes markets are inefficient and may reflect irrational behavior
- Considered more practical as it involves attempting to trade trends
- Technicians forecast prices that will happen without caring about the reasons
- Stock prices are a leading indicator of fundamental data
- Uses detailed information to calculate the intrinsic price of a security
- Assumes markets are perfectly efficient
- Involves more estimates and assumptions about different variables
- Considered more theoretical as it strives to determine an underlying intrinsic price
- Forecasts prices that should happen based on underlying reasons