A large amount of time, money and effort is spent by traders, investors and analysts examining “fundamental data”: company balance sheets, market reports, news items, supply and demand analysis. Blogs, books, newspapers and analyst reports are filled with analysis of fundamental information.
For example, the extensive blogroll on FT Alphaville currently links to 89 blogs; my rapidly unscientific survey identified that about 86 of those deal with fundamental information, and one appears to specialise in pictures of bank CEOs looking like Austin Powers. Traders and investors spend an extraordinary amount of resources investigating and analyzing the fundamentals, looking for clues about how to place their risk capital to work.
The good news is that the fundamentals do not matter. Or at least, they do not matter as much as people think they do.
Most people seem to believe that if they do their research properly, if they are more thorough and diligent than that other guy, if they have just one more piece of precious information, then they will know what to do. And then they will make their fortune.
They are wrong. The fundamentals are a tool. At best, they are an important but minor piece of the puzzle of extracting positive risk-adjusted returns. At worst, they can be highly misleading and distracting.
It is crucial to realize that traders do not get paid for predicting the fundamentals. We get paid for making money. And making money is far more about managing risk than it is about guessing how fundamental data is going to change. As Michael Covel puts it:
“Trading is trading, and the name of the game is to make money, not get an A in “How to Read a Balance Sheet“.”
Look at it this way: imagine I am like Biff in Back To The Future II, and I have a Magic Almanac from the future. Imagine that I tell you exactly what the US unemployment rate, the GDP level, the amount of crude oil in storage and the balance sheets of the top 10 largest public companies will look like in 12 months time. That would be pretty helpful, wouldn’t it? You could make some pretty good money of that, couldn’t you?
While that information would be a useful tool, there are several problems in turning that perfect knowledge into cash dollars. Even assuming that my Magic Almanac is correct, you will not know the most important things that will determine if you make money or not. Primarily, you do not know how the market is going to value a certain level of unemployment, or crude oil inventory or even a given balance sheet in the future.
Just as bad, even if you are pretty confident that the market is going from point A (today) to point D (in a year), you do not know the path the market is going to take to get there i.e. where are points B and C along the way? Without knowing that you could be taken out of your position before you get there, either by a margin call or by your own flawed and emotional brain*.
Fundamental analysis does not give answers to the vital questions of how to enter a market, what market to enter, with what position size, and when to exit. The answers to those questions are given by a traders’ risk management system. As Peter Brandt puts it,
“Analysts are paid by being right… Traders are paid by managing risk. These two skill sets are a world apart.”
Most successful traders do understand the fundamentals of their markets, but it is only a small piece of the puzzle of extracting positive risk-adjusted returns.
* No offense intended. You should know that your brain is flawed and emotional. So is mine. It is because we are descended from monkeys.