Explain it to me like I am a 5-year-old: Fundamental Analysis vs Technical Analysis

I am a graduate student pursuing a Masters in Computer Science from NYU wanting to understand finance and many of the underlying concepts. This post is meant for people who are completely new to Finance but want to have a basic understanding of the stock market. My aim here is to make the concepts easier and more understandable.

 

Whenever investing in stocks, we need to have knowledge of a few metrics to judge if the stock is worthy to be invested or not. Among various types of analysis, there are two major techniques which are used for successful investment and trading i.e. Fundamental Analysis and Technical Analysis. The main aim is to combine both the analysis to gain maximum profits.


Fundamental Analysis:


Fundamental Analysis is basically identifying the financial health of the company which can be done by checking the balance sheet of the company which helps us analyze the profit and loss. It is just like a medical report which helps us check if the person is sick or not.

Most people believe that just by looking at the Fundamental Analysis Result, we can invest in stocks and it will get us maximum profits, which is not the case most of the times.


Metaphorically speaking, if we consider our human body then what we eat i.e. our diet can be called as fundamental analysis and what type of exercises we do can be called as technical analysis. Human health is impaired depending on our diet. The more junk food we eat, the lower is the performance of our body. When the human body is backed by a healthy diet and good exercise, it lives a healthy and long life. We must try to find such combinations. Basically, for you to invest successfully, you should consider looking at both types of analysis.


With the help of technical analysis, we can take advantage of small and long-term cycles in stocks. You might have the same diet (fundamental analysis) for different types of people but the exercises (technical analysis) might differ. A young teenager might perform heavy exercises while light exercises will be beneficial for older people. Hence, along with fundamental analysis, to better understand the company and its health, technical analysis is also important.


This is why always put money in fundamentally and more importantly technically good stocks. In the stock market, it is advisable to focus on ‘What is the trend?’ rather than ‘Why this trend?’. Any stock we invest must be very liquid meaning the stocks should be easily converted to cash whenever required because that will help us exit whenever we want to. To do so, we should be aware of the stocks having low volume. Because if at any stage the volume drops to 0, then even if the price is good, we cannot sell it as there will be no buyer for it.


Technical Analysis:


This approach focuses on looking at the historical price movements and trends to predict future trends for a particular stock. It is believed that with the help of charts, it is possible to identify trends and trade based on the predicted trends. The objective of the technical analysis is to forecast the direction of future price movements.

As mentioned before, technical analysis helps both, the short term and long term traders. Long term traders can understand the long term trend, stay invested and not worry about the short term volatilities. On the other hand, short term traders can take advantage of such volatilities and based on support and resistance, can trade on different ranges.

As we can see that investing just based on fundamental analysis can be dangerous because most of the times companies manipulate their balance sheets and increase their share price, but when the bubble bursts, the company can also go bankrupt. That doesn’t mean we should avoid the fundamental analysis but keep a balance between both the approaches. Many times even if the fundamental analysis looks good, but if there is some problem then charts can help us find it. Based on different types of charts and indicators, we can decide whether to enter or exit the stock market.


 

That’s it for this post. Do check out my other posts to gain more knowledge about finance. Please do let me know if there is any other concept in finance you want me to write an article on, I will try my best to explain it in simpler terms.

Also, feel free to ask questions in the comment section. Will be happy to help you out :) Happy to connect on LinkedIn.

PS: The analogy I have used might not be 100% correct but it’s easy to understand things with a simpler analogy.

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