Date: February 1, 2010
by Roger Tan, SIAS Research
Many investors have asked me what I think of the claim that “investors can use fundamental analysis to pick stocks and technical analysis to time stocks?” My simple answer has always been “That’s absolute nonsense.”
Don’t get me wrong. Both methods have their respective merits but they are also developed based on very specific purposes and assumptions. And it is these differences that prevent these methods from being blended into a single analytical methodology.
However, that does not mean that investors cannot employ both methods in their investment strategy. What I am in fact saying is that both methods can be employed but only at the portfolio level and not at the methodology level. What this basically means is that one can divide his funds into two pools and apply one investment method to each respective pool but cannot combine the two methods into one by using one method to pick a prospective stock and the other to time entry and exit of that stock.
Why can’t the methods be “integrated”? How can you blend these methods at portfolio level? What are fundamental analysis and technical analysis really about? How does SIAS Research apply these methods? I will explain.
Technical and Fundamental Analysis – Can Fire and Water Mix?
What are fundamental and technical analysis really about? Burton Malkiel explained the two analysis methods well in his book “A Random Walk Down Wall Street”.
Malkiel explained that a technical analyst makes and interprets stock charts to predict the appropriate time to buy or sell a stock while a fundamental analyst uses the “tenets of the firm-foundation theory” to select individual stocks. While technical analysts believe that the market is only 10% logic and 90% psychology, fundamental analysts take the opposite direction – believing only in 10% psychology and 90% logic. This basic difference is the first sign that the two methods are bi-polar in nature.
Technical analysis revolves around two basic assumptions. Firstly, technical analysts believe that all available information about the company, such as earnings and dividends are already reflected in the company’s market price. Secondly, they believe that prices tend to move in trends. Therefore, “a true chartist doesn’t even care to know what business or industry a company is in, as long as he can study its stock chart“. To a technical analyst, “fundamental information on earnings and dividends is considered at best to be useless – and at worst a positive distraction“.
While the technical analyst is interested only in stock prices, the fundamentalist’s “primary concern is with what a stock is really worth”. To a fundamental analyst, price is only important after a firm’s intrinsic value is estimated to determine if the purchase (or investment) would be a good buy. Intrinsic value is determined by a firm’s ability to add value above its cost of capital.
Although a fundamental analyst can estimate the value of a company he is not able to estimate the period that price will converge to that value. To a fundamental analyst, investors are not always rational and therefore price may not always reflect the value of the company. As a result, there are opportunities to buy good companies at cheap prices. When will investors realize that they have missed a gem? That is hard to foretell. That is probably why Warren Buffett holds on to his stocks “forever”.
These two methods cannot be combined at methodology level simply because technical analysis assumes that prices reflect all available information, fundamental analysis assumes that prices may not. A fundamental analyst will give an investment call on a stock because the price is wrong and therefore a gap between price and value exist; while a technical analyst identifies opportunities in trends because price is almost always right. The saying that one can use fundamental analysis to pick stock and technical analysis to time stocks is simply paradoxical.
|Fundamental Analysis||Technical Analysis|
|Focus of Research||Value||Price|
|Attention Paid To||The Company||The Market|
|Assumption of Participants||More Logical than Psychological||More Psychological than Logical|
|Information on Company||Important||Useless/Positive Distraction|
|Price Reflects All Information about company||Not All the Time||Yes|
There is a Way to Mix Water and Oil
Though the two analysis methods cannot be combined at methodology level, it does not mean that one must practice “monogamy”. Both fundamental and technical analysis have their uses and knowing how and when to use each method is more important than trying to put both methods together.
Because technical analysis focuses on looking for patterns to determine entry and exit points and ignores the fundamental of the underlying, it is mainly used by traders and can be extended to a wide variety of asset classes such as foreign exchange and commodities. This method is useful for investors who prefer to lower their own liquidity risk by minimizing the length of their investment period.
Fundamental analysis on the other hand is useful for investors who are willing to bear liquidity risk in return for bigger rewards from picking an undervalued stock and “waiting it out”. Returns from investment should come mainly from the value-add created by the company ‐ which will take time to nurture – and not the sudden jump in price. Time is not of the essence for such investors – the size of potential returns is.
As a side note, this may explain why a majority of elderly investors prefer to use technical analysis over fundamental analysis when investing. Since they cannot bear too much liquidity risk, they would prefer trading over investing.
How can you utilise these two methods then? All you need to do is to divide your funds into two pools and use different methods on each pool. It is that simple. But how should you divide your funds?
It all depends on your financial situation and investment preference. We believe that an investor should only be picking and timing individual stocks using “excess funds” – surplus funds after allocating to a pool to achieve long term goals. Funds such as those planned for retirement or to fund children’s education should not be used for stock pick purposes.
Once you have determined the amount of excess funds, you can then decide on the division. Allocate more funds to the technical analysis pool if you prefer to keep your fund liquid and more to the fundamental analysis pool if you prefer to buy and hold onto good stocks.
Within each pool divide the money into equal investment units based on the number of investments you are prepared to take in each pool. The main purpose of this division is to improve the chances of success and reduce risk. Do be mindful that although increasing the divisor will further reduce risk it will also reduce the magnitude of returns due to smaller amounts being allocated to each “bet”. There is a statistical reason dividing the pool into equal parts but this is perhaps better left for another day’s discussion.
Stock picks in the fundamental pool is based solely on fundamental analysis and for the technical pool, technical analysis. In most instances, my own fundamental pool would not hold the same stocks as the technical pool. But there may be events that the technical pool may have an agreement with the fundamental pool resulting in a dual exposure situation for a short period of time. This excess exposure is due to incidental agreement of the methods and not because of the combination of the methods.
Illustrating the Point
Let me illustrate the above with an example. Assuming I have S$100,000 of excess funds, I would allocate S$80,000 to the fundamental pool (80%) and S$20,000 (20%) to the technical pool. I personally prefer to invest rather than trade.
For my fundamental pool, I would only want to invest into 10 companies at any one time (ie. 10% maximum exposure in each company) and only up to 5 companies at any one time (ie. 20% maximum exposure) for my technical pool. Every investment under the fundamental pool will therefore have an exposure of up to S$8,000 and S$4,000 in the technical pool.
Because I used different analysis methods for different pool of funds, the companies I have selected for each pool would differ. Now, assuming two months ago, I used my fundamental pool to invest in Q&M Dental after applying fundamental analysis techniques but signals from technical analysis done on Q&M Dental only yesterday now strongly suggested that I would be foolish not to dive into my technical pool. Taking the plunge, my exposure for a short period would then be S$12,000 (S$8,000 from the fundamental pool and S$4,000 from the technical pool) in Q&M Dental until further technical analysis suggests a sell.
I warranted that additional exposure to Q&M Dental was worthwhile because it was supported by the two different analyses to increase exposure. Furthermore, this additional exposure would only be temporary thereby minimizing my exposure to one stock. There is a statistical basis to this but again, perhaps a discussion for another time.
What if technical analysis suggested a “sell” on Q&M Dental? In this case, I would consider selling S$4,000 worth of the stock until the call is revised for that position. Therefore, my total Q&M Dental position will be reduced to S$4,000 from S$8,000.
What if I have not invested in Q&M Dental in the first place but my technical analysis suggested a “sell” call? Technically, I am supposed to short the market but I may not if I am personally not comfortable to take a “naked” short position.
Can you divide the funds in each pool heterogeneously? The answer is “Yes” but only because the subjective chances of success of those investments are higher than the other choices. But this also means that you must reduce allocation to those with lower (subjective) chances of success.
Minimize Emotional Involvement to Improve Rationality in Decision
The process discussed above is meant to illustrate the optimal use of the two methods through the use of portfolio separation. The open secret of investment success is to properly segment one’s portfolio that fits one’s needs and preference. Understanding your financial position, investment goals, and investment preference and constraints must be the first step in your investment journey. Developing investment strategy should come after.
Proper division of funds to fulfill a specific purpose will help investors minimize the involvement of emotions when investing. This will ensure that all decisions are made on rational grounds and not be swayed by ‘fear’ or ‘greed’.
Readers who wish to read more about investment insights may refer to our articles:
1. “SIAS’s 3 Dimensions of Investing: Roadmap for Your Investment Journey” by Mr David Gerald
2. “Paths to Investing Success – Do All Roads Lead to Rome?” by Yours Truly.
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