Technical analysis (TA) versus fundamental analysis (FA). What's the difference? What's better?

In this brief article I'll attempt to explain how each of the major schools of thought -- technical analysts and fundamental analysts -- operate and think.

If you're after a much more thorough education I think you would really like the conversation I had with Nick Radge, founder of The Chartist, over on the Selfwealth YouTube channel.

Fundamental Analysis (FA) explained 

Let's get one thing straight: as a business owner and long-term investor, it's fair to say I'm a fundamental investor (that said, I'm a bigger advocate of passive investing, through ETFs).A fundamental investor uses a company's financial fundamentals to make an investment decision.Hypothetically, if BHP Group (ASX: BHP) was expected to pay a dividend of 5% and BHP shares traded at a lower multiple of profit (e.g. a PE ratio of 10x) I might say "BHP shares are cheap". And if we compared BHP against another company that didn't pay a dividend and seemed more expensive (e.g. a PE ratio of 20x), a fundamental analyst might opt for investing in BHP because its 'fundamentals look better'.

Fundamental analysis is easier than ever thanks to improvements in computing power and more data being provided by the internet. This has resulted in the creation of humongous financial databases like Standard & Poor's, Thomson Reuters, Refinitiv (what Selfwealth uses), and so on.

Once a company releases its results, typically every six months or quarterly, the databases ingest the latest financial information and computers do the number crunching for us.

Most professional fundamental investors seek to get an edge by doing more research and trying to more accurately forecast fundamental factors like revenue, profit, cash flow and dividends.Given most companies in Australia report their financial results every six months, a fundamental investor is typically -- or should be -- long-term focused. As we covered not too long ago on Selfwealth Live, the best-performing companies from around the world achieve strong revenue growth over 10 years (not 10 months!).

Technical Analysis (TA) explained

A stock "trader" or someone who "dabbles" in stocks could be most accurately described as a technical analyst (or even, for the latter, a 'speculator').

A technical analyst is someone who, principally, uses two things to make trade decisions: share price & trade volume. The most basic principle is that many of the patterns that form in financial markets can reoccur or repeat.

Two of the more common phrases you'll hear from a technical analyst are...

• "Resistance" - often a company's share price will struggle, repeatedly, to reach a certain price level. For example, whole numbers (e.g. $10, $50, etc.) are typical share prices that will sometimes encounter resistance or...

• "Support" - which is the 'floor' on a share price.

For example, if shares of a company like Commonwealth Bank (ASX: CBA) traded up and down between $95.00 and $99.99 over the course of a few weeks, but struggled to trade at $100 per share, we might be inclined to say 'CBA is meeting resistance at $100'.

While technical analysis might sound like witchcraft, or wizardry, it's also a play on human psychology. After all, many people will be biased towards setting their buy or sell orders of CBA shares at $100 rather than $97.39.

They might say, "I dunno, $100 just feels like a good number." I'm sure there have been times when you have bought 5 oranges when you only needed 4 for a recipe, or 10 metres of timber when you need 9.5.

Typically, technical analysis is done in shorter windows, with more trading activity, than fundamental analysis. So it incurs higher brokerage costs -- which is good for the broker, but not for you.

For example, it's common for traders to place multiple trades every day. Whereas a fundamental investor -- like myself -- might only do one per month -- if that.

Charting 

Within technical analysis, we have something called "charting". This is a visual attempt at technical analysis.

This allows traders to do things like plot 'channels' (i.e. the general direction of a share price), use candlestick patterns, inspect moving averages (i.e. a line chart showing the average share price over 5, 30 or 200 days) and so on.

Charting can be used to visually identify and inspect resistance, support, reversals and so on.

In technical analysis, what traders seek is share price action and volume (shares traded) to confirm each other. For example, share price going up and trading going up. This is why many investing websites show the share price up top with shares traded (aka volume) down below. So much of investments industry is built around speculation and excessive trading. That's just one reason why why I do not advocate for anyone to become a technical analyst. If you are going to try it, get expert help from a licensed professional with humility and a proper track record.

Fundamental or technical analysis: what's better?

While a fundamental analyst -- like me -- will argue that technical analysis simply doesn't work, given that the 5,000 most popular trading rules have no efficacy; a technical analyst might say that many funds management studies show fund managers (who charge fees and are mostly fundamental investors) don't work.

Having worked as an analyst, interviewed hundreds of Australia's brightest investors and started, owned and run my own company, I am firmly in the fundamental & passive investing camps.

While technical analysis may work for some folks, such as Nick Radge from The Chartist who uses a time-tested growth and momentum-based trading strategy that he has refined over many years, I've come across many more successful passive index investors and fundamental investors than I have day traders.

That said, over the years I have attempted all types of trading and investing myself. Oftentimes, the best way to find out what works is to try it on for ourselves. If you plan to DIY investing my advice would be to start with small amounts of money and always keep a journal with your honest reflections.