What is fundamental analysis?
Fundamental analysis is a technique for valuing security based on its inherent worth, which comprises economic, financial, and other qualitative and quantitative elements.
When stocks appear cheap on this basis it may be undervalued and worthy of investment or to buy stocks. Stocks where the share price seems high, might mean they’re overvalued – so perhaps not worth buying just now.
So, how can you use this information?
Well, there are several ways:
1) Sitting on your hands
Fundamental analysis aims to give us insight into whether specific assets or securities are currently priced correctly, in other words, whether they offer good value. A share price might be high because the company is doing well and has a bright future, but it might also increase because people overestimate how well it will do.
Remember that no one can predict the future with 100% certainty, so any decision you make based on fundamental analysis is always going to be a gamble to some extent. With that in mind, if you think a stock is expensive, then there’s a good chance it might stay costly (or get even more costly), and if you believe a stock is cheap, then there’s a good chance it might get even more affordable. So rather than buying or selling shares outright, you could wait and see if the stock becomes more or less expensive and then buy or sell accordingly.
This approach is sometimes known as “waiting for the fat lady to sing” because you’re waiting for confirmation that the stock has either become more or less expensive than you think it is. It’s a relatively low-risk way to invest, but it can also be rather slow and frustrating if the stock you’re waiting on doesn’t move in the direction you were hoping for.
2) Trading on margin
Another way to take advantage of fundamental analysis is by trading on margin. It means borrowing money from your broker to buy more shares than you could afford with your own money. So, for example, if you think a stock looks cheap, you might borrow money from your broker and use it to buy as many shares as you can. Then, if the price of those shares does go up, hopefully enough to cover the interest on the loan plus a profit, you sell at a profit and repay your broker. However, if the share price doesn’t increase enough to make a profit for you, then you would have to either repay your debt to your broker with money from another source – or sell some of the shares that you own to pay off what’s owed.
It is something that can work well provided that:
- You do fundamental research first and find effective ways of picking good stocks.
- The market operates consistently, and you’re not unlucky enough to pick a stock that falls in value right as you buy it.
- You have the self-discipline to sell if the stock goes against you, rather than hanging on in the hope it will come back.
3) Diversifying your portfolio
The final way to use fundamental analysis is by diversifying your portfolio. It means spreading your money across several different stocks in the hope that at least some of them will do well, even if others don’t. This strategy can help you reduce the risk of losing money if your analysis is wrong about one or more stocks, but it also means you are less likely to make a large amount of money on any particular stock.
Again, diversifying your portfolio works best when combined with fundamental analysis. Diversification can work very well as long as you understand how to analyze a company’s financials and you’re not too reliant on any one particular stock
Bottom line
All three methods can be very effective when used correctly, but it’s important to remember that fundamental analysis will never be 100% accurate. So if you do decide to use these methods, always make sure you do your homework first and have a backup plan in case things go wrong. Thanks for reading!
