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Investing in Equities
Let’s begin by talking about the difference between theory and practice. Investment is about predicting the future, and making bets based upon those predictions. Investors use theories about market behaviour and economics to make predictions about how an investment portfolio might rise and fall in equity value. Investors then use these theories to create strategies for investment finance and equity finance.
Theories therefore provide a fairly solid framework for evaluating information that might affect stock values. No theory, of course, makes perfect predictions about investment behaviour. This is where the concept of risk becomes important, as investors bet on the validity and reliability of a particular theory. As most investors find out, some equity theories are better predictors than others so it is not an exact science and an investor or a stock analyst should understand that until they are fully practiced in predicting the movement of the stock markets with some success, they are going to take some knocks.
There are many different strategies and theories that investors use to make money. Two very common ideas are Fundamental Analysis and Technical Analysis. Let’s take a short look at each one.
Fundamental Analysts make a careful study of the market conditions and carefully reviews the past and present performance of a company before investing. The analysts compare the stock performance to that of the stock markets as a whole and look for opportunities where a stock may be selling below its intrinsic value. They then invest betting that the equity value will rise in the near future.
Technical Analysis is a completely different theory from fundamental analysis and is based primarily on the belief that all of the information about a stock is embedded in the price. The Technical Analyst believes that price patterns recur and/or can be extrapolated, giving a predictive value. The Technical Analyst studies the price charts of a stock and decides if the correct patterns exist to buy or sell. Investors are more concerned with price behaviour than the actual performance of a company or the true equity value. So perhaps a simple price pattern would be a period of time where the stock is bought as the price rises and at a later time the price starts falling and investors sell the stock. The analyst would look at how often a pattern like that occurs and predict where in the pattern the stock price is today. Thereby making a decision to buy or sell. These analysts use stock performance as an indicator of how investors see stock trends and hence the stock’s worthiness as an equity investment or a good addition to their stock portfolio.
Not all investors use theories to construct their portfolios. Some investors use their own ideas and instincts. Others use ideas and even entire sections from several theories. Still others base their entire portfolios on a favoured set of ideas from an equity theory. We are going to turn our attention now to some of the quantitative theories about market behaviour. These theories use strict statistical analysis and modelling in order to construct efficient portfolios. Let’s take a closer look.
An important tenant of equity theory is that the market is efficient. This means that the price of any stock already accurately embodies all available public information. If the goal of an investor is to “make money,” this assumption implies that an investor only makes money when their predictions are different than the consensus and their predictions are correct. Stated in another manner, if the market is efficient, the market price will accurately reflect a security’s “intrinsic value.”
Okay, let’s recap on the three main theories we have discussed.
Fundamental Analysis: Concentrates on careful evaluation of an industry and individual companies to choose stocks.
Technical Analysis: Concentrates on patterns in price behaviour.
Quantitative Theories: Concentrate on finding efficient portfolios based upon strict statistical analysis.
Now lets move on to some more underlying concepts. Investment management rests upon some common beliefs about the nature of risk and return. We will discuss risk in the next article.