There are two common types of approaches when investigating a stock investment: fundamental analysis and technical analysis. Fundamental analysis focuses on the company. It looks at things like balance sheets, book value and price earnings ratios, and it is used to determine if the stock being considered is a good long term investment. Technical analysis focuses almost entirely on the stock price and its patterns.
The assumption with fundamental analysis is that the stock price will reflect the profitability of the issuing company. The more profitable the company is, the higher the stock price. There may be a lag between increased profits and increased stock price, but investors using fundamental analysis are certain that the one follows the other. If there is a lag, then it represents a buying opportunity.
Technical analysis is also referred to as chart analysis. Technical analysis is based on completely different assumptions. With a technical analysis, the starting premise is that the market is made up of a large group of people. The assumption is that this large group of people will behave in predictable patterns.
The challenge for technical analysts is to find these patterns in the price movements of the stock. The patterns tend to become obscured in the price trends, since outside events also tend to influence the movement of the stock price. These outside events tend to add “noise” to the patterns that mask or change the price patterns of the stock. Sometimes, outside events interrupt the pattern completely and start a new pattern. An example is an event like the September 11 attack in New York, which had a huge effect on stock prices.
Technical analysis uses many tools or techniques. Elliot Wave theory, moving averages, chart analysis, stochastic analysis, trend analysis, and Bollinger bands are just a few of the common ones. However, the goal is always the same: to predict the price movement of the stock. If the prediction is correct, then a profit is made.
Fundamental analysis is considered more conservative than a technical analysis approach. In most cases, if a company has been making money, then it will continue to make money in the future. There is far less agreement as to the soundness of the basis for technical analysis. The appeal of technical analysis is the hope or perception that one can make a profit more quickly than with a buy and hold approach, the typical end result of a fundamental analysis approach.