As investors we would have diverse investment strategies with the primary aim to achieve superior performance, which would also mean a higher rate of return on our investments. All investment strategies can be broadly classified under 4 approaches, which are explained below.
Fundamental approach: In this approach the investor is concerned with the intrinsic value of the investment instrument. Given below are the basic rules followed by the fundamental investor.
There is an intrinsic value of a security, which in turn is dependent on the underlying economic factors. This intrinsic value can be ascertained by an in-depth analysis of the fundamental or economic factors related to an economy, industry and company.
At any point in time, many securities have current market prices, which are different from their intrinsic values. However, sometime in the future the current market price would become the same as its intrinsic value. We as fundamental investors can achieve superior results by buying undervalued securities and selling overvalued securities.
Psychological approach: The psychological investor would base his investment decision on the premise that stock prices are guided by emotions and not reason. This would imply that the stock prices are influenced by the prevalent mood of the investors. This mood would swing and oscillate between the two extremes of 'greed' and 'fear'. When 'greed' has the lead stock prices tend to achieve dizzy heights. And when 'fear' takes over stock prices get depressed to lower than lower levels.
As psychic values seem to be more important than intrinsic values, it is suggested that it would be more profitable to analyze investor behaviour as the market is swept by optimism and pessimism. Which seem to alternate one after the other. This approach is also called 'Castle-in-the-air' theory. In this approach the investor uses some tools of technical analysis, with a view to study the internal market data, towards developing trading rules to make profits.
In technical analysis the basic premise is that price movement of stocks have certain persistent and recurring patterns, which can be derived from market trading data. Technical analysts use many tools like bar charts, point and figure charts, moving average analysis, market breadth analysis amongst others.
Academic approach: Over the years, the academics have studied many aspects of the securities market and have developed advanced methods of analysis. The basic rules are:
The stock markets are efficient and react rationally and fast to the information flow over time. So, the current market price would reflect its intrinsic value at all times. This would mean "Current market price = Intrinsic value".
Stock prices behave in a random fashion and successive price changes are independent of each other. Thus, present price behavior can not predict future price behavior.
In the securities market there is a positive and linear relationship between risk and return. That is the expected return from a security has a linear relationship with the systemic or non-diversifiable risk of the market.
Eclectic approach: This approach draws upon all the 3 approaches discussed above. The basic rules of this approach are:
1. Fundamental analysis would help us in establishing standards and benchmarks.
2. Technical analysis would help us gauge the current investor mood and the relative strength of demand and supply.
3. The market is neither well ordered nor speculative. The market has imperfections, but reacts reasonably well to the flow of information. Although some securities would be mispriced, there is a positive correlation between risk and return.