An Insight Into Stock Market Investing
The easiest way to make money is—create something of such value that everybody wants and go out and give and create value, the money comes automatically.
—Jordan Belfort, The Wolf of Wall Street
The stock market has always been intensely followed and studied for centuries, and yet it is not often understood or predicted. Individuals and corporations have either made a fortune or lost one, through the stock market. However, there are several methods used by analysts and investors to predict and understand the markets, and to know when exactly selling and buying will result in the highest possible profit. The two most widely used and important tools are fundamental analysis and technical analysis.
A key concept of analysing the stock trends involves the intrinsic value of the stock, which is the true value of the stock. It is a value calculated by a team of analysts and can be higher, lower or equal to the price at which the stock is currently being traded.
Fundamental analysis is the method of determining the intrinsic value of the stock. Stock traders hunt the market for stocks whose traded values do not match their intrinsic values. If the said stock’s market value is higher than the intrinsic value of the stock, the stock is said to be overvalued, and selling of the concerned stock is crucial to avoid losses. Likewise, if the market value of the stock is less than the intrinsic value of the stock, buying of the concerned stock is advised to make profits. An undervalued stock’s price can be potentially higher than the current rate, and hence it stands a better chance to gain profits in the future. Similarly, an overvalued stock will potentially see a fall in prices shortly, and hence selling of the stock in the present is advised to avoid losses in the future.
Fundamental analysis models use various parameters to determine the intrinsic value of the stock. These factors vary across analysts, and there is no certified algorithm of doing fundamental analysis. Broadly, the commonly used parameters can be split into two categories—qualitative and quantitative.
As the names suggest, qualitative factors are those who deal with the nature of the stock or company and are not presented as numbers. On the other hand, quantitative factors are those who are quantified as numbers and amounts. Both factors are extremely significant and complement each other while determining the intrinsic value of the stock.
Quantitative factors, or fundamentals, are hard numbers that are the measurable characteristics of a business, making financial statements the best source of quantitative data. Revenue, profits, assets and sales are some commonly used quantitative fundamentals.
However, qualitative fundamentals are a characteristic measure of how well a business is running and takes into account factors such as business model, brand value, management, governance, etc. Essentially, these are factors that protect a company’s sales and revenue and defend it against the competition, earning the term economic moat.
Technical analysis follows a rather different philosophy from fundamental analysis. The most basic assumption of Technical analysis is based on the idea that the stock price reflects the publicly available information, that is, the market and intrinsic values of the shares are equal, and hence relies on statistical models that attempt to determine trends in the price of stocks. This is consistent with another theory in economics known as the Efficient Market Hypothesis (EMH), which states that it is impossible to locate over or undervalued stocks in the market.
Technical analysis relies on three fundamental assumptions, namely:
- The market discounts everything (same as the assumption mentioned above).
- All prices move in trends.
- History tends to repeat itself.
Technical analysts apply the knowledge of various statistical tools and charts to create analysis models that help them identify patterns and trends in the value of the stocks. This, in turn, helps them decide the right time to buy and sell shares, and determine the quantity of buying or selling.
Comparison Between Fundamental and Technical Analysis
The fundamental analysis gives investors a long term outlook of the market. The fundamental analysis not only tells you what shares to buy, but it gives you an idea of the company’s performance and health. It gives one an idea as to whether a company is worth investing in. However, the fundamental analysis does not help traders who are looking to make gains in the short run. While it tells you whether it is a good idea to buy or sell a particular stock, it does not help you determine when exactly the market is going to change. It assumes that the market value of the stock will equal its intrinsic value in the long run, but does not provide a clear definition for what the “long-run” means. This uncertainty encourages analysts to resort to technical analysis instead.
Technical analysis gives traders an insight into not just the changes in stock value, but also a timeframe that traders can refer to. It tells them when to sell and when to buy a particular stock, and it also helps them determine how much to invest in the concerned stock. Thus, it is beneficial for traders looking to make short term investment calls and decisions. Trends in the stock market, however, do not always repeat themselves entirely in the future, and this makes it difficult to make decisions for the long run using technical analysis.
However, neither fundamental nor technical analyses a 100 per cent accurate and must be looked at critically while making a decision. While the two methods have enjoyed both success and failure on numerous occasions, the skill and experience of the trader and analyst are equally important in creating a model, interpreting the data and making a decision.
The risk vs reward for a given share, external factors that affect the market (such as government laws), overall impact and popularity of the industry, and historic name and performance of the concerned company play a role in the decision-making process. No trader will ever restrict themselves to one particular model while neglecting the rest. It is important to be inclusive and vigilant to rely on your best judgement while making the final decisions.
Written by: Shrenik Kalambur, of The Economics and Finance Society of Manipal
Edited by: Jahnvi Singh, of The MIT Post
Featured image credits: ESOM