Lesson 5: How fundamental and technical analysis can help you build a strong investment portfolio

Fundamental analysis helps investors assess the true value and financial health of an investment, while technical analysis looks at price movements and market trends. Both methods can be applied to many types of investments, but they’re often used in different situations. For example, fundamental analysis is commonly used for stocks, bonds, real estate and commodities, focusing on aspects like financial performance, earnings and overall market conditions.

On the other hand, technical analysis is often applied to stocks, forex, futures contracts, options and cryptocurrencies, concentrating on price changes, trading volume and market patterns. Many investors find it beneficial to use a combination of both approaches, especially for stocks and real estate investment trusts (REITs), to gain a well-rounded understanding of potential investments.

In this article, we’ll introduce you to both approaches.

Let’s start with a stock example. Fundamental analysis on a stock is like getting to know a company from the inside out. It examines a company's financial health, including its revenue, profit and overall business profile. Fundamental analysts look at things like balance sheets, income statements and market trends to decide whether a stock is undervalued or overvalued at its current price. Essentially, it helps investors understand the true value of a company and make informed decisions about buying or selling the stock.

You might start by reading current analyst reports on some of the industries or companies you’re considering as investments. Analyst reports help you understand a company’s business, key factors for its profitability and perhaps a view into its history and possible future business path. You’ll also develop a feeling for how the business world sees the company — analyst ratings can tell you how optimistic Wall Street or Bay Street is about a company’s future. As you read through a report or conduct your own research, here are some things to think about:

1. Study the industry. Look at the company's place in its industry, including its market share, competition and industry trends.
2. Consider the management team. Evaluate the company's leadership and management team, including their track record and experience.
3. Explore future growth potential. Consider the company's growth prospects, including its plans for expanding its business, entering new markets or launching new products.
4. Put it all together. Consider current events and the current economic climate as they relate to the company you’re studying. The overall economy, regulation or competition might all be important for a complete picture. 

The goal of your research is to understand the company's strengths and weaknesses, and how it’s positioned for future success. Some market professionals recommend that you look for companies with a strong financial track record, solid management and a competitive advantage in their industry. Another approach is to consider investing in companies that have overcome adversity and experienced a decline in stock price, but are now showing signs of growth and the potential for future gains.

Technical analysis is all about the numbers and charts. It focuses on an investment’s historical price movements and trading volumes to predict future price trends. Think of it as reading the market's mood through patterns and indicators. Traders use various tools and charts to identify trends and make decisions based on price movements rather than a company's fundamentals.

Here are some of the things you should know about technical analysis:

1. What technical analysis involves – Looking at past market data, such as price and volume trends, to make predictions about a stock's future performance.
2. Common techniques – Common technical analysis techniques include chart pattern recognition, trend analysis and moving averages.
3. Best used together – For some investments like stocks, technical analysis is best used in conjunction with fundamental analysis, where you develop an understanding of a company's financial health and future growth prospects.

One common way technical analysis is used is to narrow down the number of stocks under consideration for a portfolio. Here are just two examples of how traders use technical analysis.

Use volume data. There are a number of ways to use a stock’s volume information. You might decide to trade stocks that have a certain minimum amount of daily volume, as a way to ensure that the stock is reasonably liquid and can be bought or sold with relative ease. For example, you perform an analysis that ranks all financial stocks by daily trading volume and consider investing in those with daily volume in the top 100. You could also scan for unusual changes in daily volume, as that might point to increased investor interest in a stock, positive or negative. This can be the result of many things. Perhaps a news story breaks that’s relevant to that stock or the stock reaches a price that attracts traders’ interest.

Use momentum indicators. Some technical traders look for strong, up-trending stocks for potential buying opportunities. One way to identify this is to use moving averages, which are trend-following indicators that smooth out day-to-day price movements to show a stock's general direction over time. Moving averages can also help to identify support and resistance levels. Support is where downward trends tend to wane as buying pressure overcomes selling pressure. In contrast, resistance often occurs at a price level where selling pressure overcomes buying pressure and the stock may, at least temporarily, encounter difficulty moving higher.

Are you wondering what kind of technical analysis has the best track record for picking winning stocks?

The truth is the effectiveness of technical analysis varies — there’s no single technique that has the best track record for picking winning stocks. Think of technical analysis like another tool in your toolkit that can help you understand price action. Put simply, a stock’s price reflects how investors perceive and value it at that moment.

While technical analysis incorporates an analysis of a stock’s past price performance, it’s not a guarantee of future performance. When used together with fundamental analysis, however, technical analysis can improve your understanding and let you make better informed investment decisions.

Once you’re ready to start, log onto your Investor’s Edge account and go to Quotes and Research, where you’ll find a number of tools to conduct fundamental and technical analysis.

Investing in individual stocks is often a long-term commitment, and it's important to have patience and a well-thought-out strategy. Don’t forget that a company’s situation can change, and it’s smart to keep up with developments once you’ve included a stock in your portfolio. With the right approach and the right resources, you can increase your chances of picking a great stock that appreciates over time.