First, let me start with the easiest part, technical analysis. It is a graphical representation of statistical measurements and stock prices to help traders visualize the data. Due to the simplicity of technical analysis, its importance is overvalued by many amateur traders or lazy people who don’t want to spend time on research or company valuations. Traders use different indicators and graphic patterns to evaluate the current stock trend and the strength of the trend. Technical analysis tries to examine the current state of the stock’s price, falling, rising, and how volatile it is. But technical analysis cannot, as many believe, forecast the future price movements. And let me explain why. The stock price movements depend on many factors. Many years ago, I tried to assign the factors that can affect the stock price. I created a stress test model that reflected more than 100 essential points that can influence the stock price. But this model did not work. Because factors inside this model were sometimes contradictory, you couldn’t assign the importance to each factor because it heavily depends on the company’s internal factors, such as financial stability, operational risks, and other external factors such as institutional volumes and large shareholder sell-offs or purchases. Let me give you an example to illustrate that. The technical analyst or trader can analyze and conclude that the stock is supposed to go higher, at least what the support and resistance, indicators analysis, and graph analysis can tell the trader. And his conclusion can work perfectly till some point.
Now suppose that one large brokerage company is holding the same stock. And one day, the risk management department of that company says that they created a new risk management policy according to which the brokerage company now has an over-limit of that particular stock in the portfolio. The traders must sell some portion of this stock on the market in order not to violate the limits policy. If the brokerage company holds a larger stock portion and the traders sell at the market, they can decrease the stock price. And the stock price will fall even if the technical analysis shows that the stock is growing now. The large sale could trigger a panic, and other larger traders will start selling the same stock. And now, the technical trader would have the problem because he relied on a technical analysis that said to him that the stock would rise. But the stock is now falling, and if he uses technical analysis again, the same indicators and models will show him to close the position. This is just a small example and one of many cases. Let’s consider another example. The trader made his technical analysis, and the stock was supposed to rise. But the company changed its development plans and said that it would face higher costs. The stock price will start falling because analysts can reconsider their previous forecast, lowering the target prices. And many factors can be contradictory, and you never know what would be the most important and when something negative happens. These factors can include but are not limited to the company’s financial reports, operational, reputational risks, product management, institutional sell-offs, industry shifts, wars, natural disasters, retail investor’s panic, market sell-off, economic slowdown, political tensions, and a lot more. Technical analysis cannot forecast what would be the outcome for the stock price if the consequences mentioned above would arise because technical analysis only examines the historical or past stock price movements.
Now, let’s consider the fundamental analysis and discuss why it cannot predict future stock prices. Fundamental analysis looks at the company’s financial reports, operational plans, industry, competitors, and money market rates. All this examination is done to forecast the future company’s financial stability and forecast company costs and revenues, and calculate the stock target price based on analysts’ forecasts. Unfortunately, some beginner investors think that if fundamental analysis calculates the stock’s target price based on a company’s financial forecasts, it can forecast its future price. This is not the case. The problem with this approach is that analysts’ financial forecasts change regularly. It depends on the company’s goals and actual data. Analysts, for example, can change the WACC rate if the money market rate increases, making the cost of money more expensive, or analysts can increase the forecasted costs if the company management announces that the company will hire new employees, for example. These measures will negatively affect the stock target price, and the market price can fall due to decreased investor sentiment. During my professional career, I had seen many cases when a brokerage company assigned a positive rating to the stock they analyzed, with 20% growth potential (target price is 20% above its market price) but then when the company released the actual quarterly financial report. The numbers are worse than analysts expected; the analysts lower the growth prospects or even decrease them. Would you sell your stock in what case?
As you can see, the fundamental analysis cannot forecast the future stock price because the data and analysts’ assumptions can change rapidly. But you can ask: “why do you need to calculate the stock target price and use the fundamental analysis then?” You do this to answer the question, is the stock’s current price expansive, or is it trading cheap, based on analysts’ forecasts. In simple words, use fundamental analysis to find stocks trading cheaper than their peers and stocks those companies have good financial growth prospects. Your goal is to use fundamental analysis to find great stocks now. The valuations can change later, but at the time of your purchase, you need to know whether you are overpaying or not. But don’t think that fundamental analysis predicts the stock price in the future.
Now you know how you can adequately use technical and fundamental analysis. I hope my article was helpful. If you want to find great stocks that will be tailored for your investment strategy and if you’re going to construct a well-diversified, efficient investment portfolio, try using my app, Diversset. You don’t have to have the financial knowledge to use my app. All you do is answer four simple questions. Based on your answers, the app helps you find stocks and ETFs and constructs your efficient investment portfolio with an assets weight distributed to get the lowest possible expected loss, given your required return.