Pretty much every investor uses one of three general investment strategies. These are: fundamental analysis, technical analysis and buying and holding the market. A brief examination of each of these techniques will help an investor decide which best suits their personal profile.
Fundamental Analysis
The most straightforward approach of fundamental analysis is a basic examination of a stock versus the value of the company and its expected future earnings. Based on the company’s financial publications it should be relatively easy to determine weather a stock is undervalued, overvalued or somewhere in-between. The trader assumes that the market price will correct itself and the price per share will consequently go up or down, unless there are any unforeseen events or hidden value traps.
Technical Analysis
Using technical analysis, the investor makes an attempt to predict future share prices based on the direction of the market, trading volumes and past prices. This approach assumes that the market and individual stock prices loosely follow discernible patterns, or at least stay within a certain bandwidth of it. Once the beginning of a pattern is identified, the remainder of the pattern can theoretically be predicted, hopefully well enough to yield returns in excess of the general market. Research has shown that solely using technical analysis as your strategy, does not work well. Yet, there are some indicators such as pivot point resistance or support levels that can actually hold up, most likely due to the wide acceptance and adoption of the method under the professional traders.
Buying and Holding the Market
The approach of “buying and holding the market” is to have a portfolio that could hold it’s benchmark against the market performance. For this strategy the investor buys a basket of stock that resembles the stock market or the S&P 500 assuming that the overall direction of the market performance is upward. The investor buys a large number of diversified stocks and does not need to buy every single stock in the index, although that could be achieved by buying stocks of an S&P 500 Index mutual fund. This approach can be used as a benchmark performance tool, as no other investment approach is valid unless it’s able to outperform the stock market over the long run. In the event that investment approaches do perform above market performance with the same risk, the difference is called excess return, which represents the added value of the used investment approach.
The investment approach you decide to use depends on your conceptual view of the two principal stock market theories. In the light of the efficient market theory, the stock price reflects all publicly available information about the company in question, which results in the trading price coming very close to the true value of the share price. Meaning that on average the price reflects the fair value of the stock, but not all the time, as variations of this price can exist. On the other hand, there’s the school of thought that these prices are unpredictable and too random, and cannot be used to generate excess returns. In that case, there is no point in using the fundamental approach seeking stocks that are selling under their actual value. Alternatively, one could concentrate more on developing a more efficient portfolio, instead of selecting a certain kind of stock. This would be a portfolio that provides returns closest to the market’s return at a specified level of market risk. The investor simply determines the amount of risk that is acceptable and builds the portfolio based accordingly.
Investors believing that the market is not efficient for the reason that buyers receive, perceive and evaluate information differently, causing the prices to deviate from their true value can look for undervalued stocks through diligent analysis. Going forward, this would enable them to outperform the benchmark of buying and holding the market. As backed by many studies it’s safe to assume that the market is often inefficient and therefore there are numerous ways of outperforming the market with your portfolio. Your excess returns can generally be 2 -6 percent at a risk free rate. Anything higher is most likely an abnormal return, which is the out-performance over the risk-adjusted return. Just beware, as this can also be a negative abnormal return. Nevertheless a small consistent excess return can also lead to great wealth.
Simon Huntsfield is Director of Planning & Analysis for Midas International investment banking and brokerage located in Dubai, London, Hong Kong and Sydney
