[This is part of the series: Technical Analysis > Fundamental Analysis]
Traders that use fundamental analysis have an issue.
It’s hard to tell if they know what they are doing, or not.
I love that example of making investors randomly guess – and then through pure chance, someone eventually looks like a genius.
I forget who said it.
But, it goes something like this:
Say there are 300,000 financial advisors in the USA, and you make each of them go long, or short, the S&P 500 from Jan 1 – Dec 30.
If each of them picked long, or short, based on a coin toss – at the end of one year there would be 150,000 who made a correct prediction.
If we continue this exercise, it looks like this:
Year Number Correct In All Years
18 1
This means that based on complete chance, someone can predict the correct direction of the market each year – for 18 years in a row.
This brings me to my point: It is hard to trade using fundamental analysis.
This is because when you are using fundamental analysis, it is hard to tell if you were right or wrong – or, if you just got lucky.
1. Right
You wanted to predict the price of cotton. You looked at the fundamentals. You measured and correlated supply and demand. You did regressions. You predicted higher prices. And low-and-behold, prices went higher. You were right!
Or were you? It’s hard to tell.
What if you were right, but for a reason you had not accounted for?
What if you were dead wrong in your analysis, but an outside variable made your prediction look correct, despite your misplaced analysis?
Like I said, it’s hard to tell for sure.
2. Wrong
You wanted to predict the price of cotton. You predicted higher prices. And prices went lower. Who cares the reason. A losing trade is a losing trade. Cut losses and run.
Don’t forget that timing and magnitude are also an issue.
Not only does it matter that prices go up or down, it also matters by how much they go up or down, and when they go up or down.
3. Got Lucky
You do all the fundamental analysis in the world and keep calling the market right. You are a trading genius. Or are you? Maybe some years you get it right. Other years the market goes your way, even despite your misguided analysis. Are you, really, a trading genius? Or, are you someone who got lucky?
That’s my point.
With fundamental analysis, it’s hard to tell.
Fundamental analysis is also too much to follow.
Technical analysis, on the other hand is just a numbers game of managing risk.
I say: Stick to what works.
