Fundamental analysis is based on the notion that every asset has a real, fair value. However, at certain times, for example when traders have not yet taken account of new factors affecting this value, the market may not necessarily reflect the asset's true worth. This results in the price being higher or lower than it really should be.
If you can identify when an asset is trading at a price that differs from its real value, you may have an opportunity to profit.
That's because in these circumstances, fundamental analysts believe, the price will tend to naturally 'correct' over time, gravitating towards its real, fair value. So in fundamental analysis your aim is to discover assets that are currently under-priced or over-priced, then place trades to capitalise on their potential movements as the value corrects.
To illustrate how this works, imagine you see an attractive house for sale in an unpopular, run-down area. Suppose you do some research and discover the district is soon to undergo a major regeneration project - you might be able to buy the property at a low cost then benefit as buyers start to recognise its value, driving up the price.
A fundamental analyst might do something similar by buying financial assets that have hidden potential - particularly company shares, which we'll focus on in this course.
While both technical and fundamental analysis involve using information that's available now to predict how a market might behave in future, they do this in different ways.
When you conduct technical analysis, you focus exclusively on price data and movements, seeking trends and patterns that indicate the likely future direction of a market. In fundamental analysis, on the other hand, you take a more holistic view and consider all the circumstances surrounding the market. You might evaluate the general health and wellbeing of:
This could include assessing all kinds of factors, from a whole country/region's employment rates or manufacturing output right down to an individual company's cash flow and expenditure. Fundamental analysis is often said to be more rigorous and comprehensive than technical analysis because everything that can affect the asset's value is studied and taken into consideration, not just price data and chart patterns.
In practice, although you may hear people advocating the use of one form of analysis over the other, it's normally wise to combine elements from both types if you want the fullest and most accurate picture of a market's likely behaviour.