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The pros & cons of fundamental analysis

So why would one want to use fundamental analysis? As we shortly mentioned in the introduction to this course, the goal of fundamental analysis is to make an estimation of what you think is a fair value for an asset. However, even though we can use fundamental analysis to make an estimation of what we think is a fair value, that doesn’t mean that at the moment that asset has to trade at that certain level. At any given time, an asset can be undervalued or overvalued compared to what you believe as fair value. This is a really important concept because it can give us great opportunities but also provide us with certain threats!

Let me try to make this a little bit clearer through the idea of Mr. Market, an allegory created by investor Benjamin Graham: Imagine that you are one of the two owners of a business, along with a partner called Mr. Market. Your partner, Mr. Market, is what we would call a manic-depressive person. His estimates of the business’s value can fluctuate wildly from being very pessimistic to being overly optimistic. On his pessimistic days, your partner is willing to sell you his share of the business at a price much below what you perceive to be intrinsic value. On optimistic days, your partner is willing to buy your share of the business at a price that is much higher than what you perceive to be intrinsic value. You are free to decline your partner’s offer, since he will always come with a new (sometimes very different) offer the next day.

This is very similar to how the actual market works. Given the fact that we live in a free and open market place, assets will trade all over the map. On some days, there will be motivated buyers that are buying the price up. On other days, there will be motivated sellers that will drive the price down. This can give us great opportunities when we want to buy undervalued assets or sell overvalued assets, but we also have to be mindful that it can take a long time for such a situation to show up. We have to understand that the market is always the final arbiter!

There are a few traps that you can step into when you use fundamental analysis to buy or sell assets.

There have been several examples of people who were in need of cash money to pay their bills. If you get caught in a situation where you HAVE to sell an asset to generate money to live, you are not necessarily going to see fair fundamental prices because that trade NEEDS to be done. You NEED that money. Thus, those that have to sell are not necessarily going to see ‘fair’ fundamental valuation prices for trades that need to be done.

On the other hand, those that bought what they perceive to be of value may have to sit on their investment for some time. If the other participants in a market do not recognize the fair value of your asset, you will have to wait a long time before you can sell it at fair value or even at a premium.

These are very important concepts to understanding a fundamental investor’s mindset. Ideally, a fundamental investor does not have a time horizon on their investment. They honestly believe their asset is trading at a discount to what they believe as the fair value of that asset is and they have the patience, discipline and ability to sit on their asset until it trades at the right price.

This also means that if you are a true fundamental analyst, you simply cannot buy an asset if it is overvalued! In some cases, this can be a tough choice for fundamental investors. Because sometimes markets do go into bubbles where fundamentally prices don’t make sense but there could still be money to be made. In the case of crypto, you might have missed out on a lot of gains if you stuck to the fundamentals. On the other hand, it could have also saved you from a lot of losses. Just be mindful that fundamental analysis can get very tricky when complete markets or industries show signs of being in a bubble!

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