Coming to terms: Technical, fundamental analysis

The Motley Fool

In the investing world, there are people who believe in the fundamental analysis of stocks and people who prefer a technical analysis.

What's the difference, and what are the pros and cons?

Think twice before embracing technical analysis; most good investors prefer fundamental analysis of stocks.

Fundamental analysts invest based on factors such as the quality of a company's management, growth prospects, return on equity, price-to-earnings ratio and macroeconomic factors.

In contrast, technical analysts invest based on a company's stock price movement and volume.

Fundamental analysts explain that shares of a company's stock represent a piece of a business, and that investors are buying a piece of that company's future cash-flow generation.

Technical analysts believe that price patterns repeat themselves, because we humans react similarly to similar market events — so they look for patterns.

Technical analysts ignore profitability, sales growth, debt position, industry, management, regulatory environment, country of operations, etc.

If two companies, no matter how wildly different, happen to have similar historical charts, a technical analyst will predict similar outcomes for each.

You don't have to look too far to find empirical evidence backing up the merits of fundamental analysis.

The pantheon of successful investors tells the story. Ben Graham, Warren Buffett, Peter Lynch, John Templeton, Shelby Davis, Philip Fisher, George Soros, David Dreman, John Neff and many others all soundly whomped the market using fundamental analysis.

They all have different approaches, but there isn't a technical analyst in the bunch.

An October 2009 study by New Zealand's Massey University tested more than 5,000 technical analysis strategies in 49 different countries.

Not one strategy generated returns that aren't predicted by chance.

So if you hear an anecdotal story of technical analysis glory, remember that a broken clock is right twice a day.

A bad strategy can win you money based purely on chance, especially in the short term.

The worst poker player at the table may double up early, but he's best advised to take the money and run.

The evidence strongly suggests that buying stocks using technical analysis will lose you money.