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Newsletter

2010 3rd Edition (Other Editions)

THREE THEORIES OF INVESTMENT

There are three major schools of thought concerning investing in securities. Not all investors come to the market with the same purpose in mind. Some are speculators, willing to take big risks in the hope of making big profits. Some have definite goals in mind, such as providing funds for retirement or for their children's education. The individual goals differ, and so do the theories about how to achieve those goals.

FUNDAMENTAL ANALYSIS

Fundamental analysis is an approach to stock market trading based on the study of economic trends and of the performances of individual firms and industries. An ideal portfolio, in this view, contains securities whose potential returns are highest relative to their current market prices. The analysis starts with a study of factors that affect the whole market. Economic forecasts are studied in detail and evaluated.

Then factors affecting each individual industry are considered, such as how much a large budget deficit could affect interest rates. Finally, the analyst looks at individual firms, and might even do some market research. The search is for extra information that would give a clue that other investors have undervalued or overvalued the firm's stock.

This is a highly favored approach to investment among professionals. Thousands of highly trained analysts work for brokerage firms and institutional investors such as mutual and pension funds, or give advice through newsletters and financial newspapers.

INVESTOR BEHAVIOR

Another school of thought believes in studying the behavior of other investors rather than the companies that issue the stocks. These are the technical analysts. They study past stock movement to find clues to future behavior of investors.

An example of this is the "head and shoulders top" pattern that they look for in the price chart of a stock. This pattern shows a small peak followed by some decline to form left shoulder. Then comes a higher peak - the head - followed by another decline, but before it reaches the level of the previous low, it rises again for the right shoulder. Then a line is drawn connecting the previous low points, and this is called the neckline.

The theory has it that if the price drops from the right shoulder to the neckline it should be sold at this point because it is heading for a long decline. There are supposedly hundreds of such patterns that could give a technical analyst a clue as to how a certain stock will fare, not all as obvious as the one outlined here. This system does have a lot of support on Wall Street, though it is not given much credence by the fundamental analysts.

Example: "Head and Shoulders Top"

EFFICIENT MARKET SELECTION

The third major approach is very different from either of the approaches mentioned already. The Efficient Market Hypothesis (EMH) assumes that markets are efficient processors of information, and that securities prices already reflect all the information available at any given time. Therefore, attempts to speculate on extra information are fruitless because all information is already applied.

Proponents of the EMH approach offer this advice: choose the general types of securities you want in a portfolio based on the amount of risk desired and your need for cash flow. Diversify the portfolio within these general types, so you spread the risk and then hold onto it. EMH does not recommend trading on the advice of analysts and speculators, but it does concede that it is the trading of these analysts and speculators that makes the market efficient in the first place. Their research provides the market with its current information.

These are just three general and broad approaches to the challenge of playing the market, and it might help the less experienced investor become more aware of the complexities of the stock market to realize that three such diverse theories could all have some support among the experts on Wall Street.