The Methods to Analyze
I. Fundamental analysis. Here, the analyst evaluates the fundamentals of the company viz. the Company’s management, Competitive Position in its industry, Growth Prospects, Financial Statements, Regulatory Environment etc. Accordingly, decisions are taken to buy, hold or sell the investments are suggested.
II. Technical Analysis is a study of past price behavior of the markets and individual stocks, to predict their future direction. The following are key assumptions underlying technical analysis.
- Market price of a stock depends only on its supply and demand. The various factors driving the stock price are captured in the supply and demand.
- Stock prices and markets in general follow a trend that persists for a reasonable period of time.
- The market gives enough indication of changes in the trend, to guide the technical analyst in investment decisions.
A technical analyst bases investment decisions on share prices and trading volumes, which are believed to capture and predict human behavior. The belief is that the entire market knows more about any stock than an individual analyst. This knowledge of the entire market is captured in the price and volumes in the market. Since technical analysts use charts to read the market, they are also called chartists.
Fundamental v/s Technical Analysis
Both streams of analysts are strongly committed to their approach to stock analysis. Fundamental analysts often decry the technical analysts, who do not seem to consider the business, earnings or management of the companies to invest in. Technical analysts, on the other hand, are happy about the frequency of data they work with – on any trading day there is a continuous stream of price and volume data.
Fundamental analysts receive earnings information every quarter; companies may also share some sales information every month. It is generally accepted that fundamental analysis aids decisions on buy / sell / hold. Once the decision is taken, timing of the implementation can be guided by technical analysis.
Day trading and other shorter term investment approaches depend on technical calls.
III. Product Analysis. Here the analyst looks at cash inflows and outflows as typically investment is made in the present time, and inflows come in the future. Some investments earn returns in the form of a regular income. Such returns flow in periodically, though the rupee value of returns may vary from one period to another. Dividend from shares, interest income received from bonds and deposits and rent earned on house property are examples of regular incomes earned from investments. For some investments, such as bank deposits, the interest payment, which is the regular return, is computed by applying the rate of return to the principal. Therefore, analyst looking at the risk to an investment depends on the use to which the money is put. The common types of risk that affect investments include inflation risk, default risk, reinvestment risk, call risk, marketability or liquidity risk, market or price risk. In order to minimize investment risk an investor needs to do the following:
- Identify the risks applicable to an investment
- Measure the risk
- Manage the risk appropriately
Risks in investments can be managed for each investment or at the portfolio level so that the impact on the overall financial situation of the investor is reduced.
Therefore, analysts conduct Product analysis in terms of Asset classes have three key attributes:
- First, each asset class has distinctive risk and return features.
- Second, factors that impact the risk and return within an asset class are similar; but risk-return factors across asset classes are different.
- Third, the performance of an investment in an asset class can be evaluated against its relevant benchmark.
IV. Behavioral Bias Investment Decision Making involves Creating and managing a portfolio at the level of the fund manager or at the investor level requires investment decisions to be made on which asset classes to invest in, how to invest, timing of entry and exits and reviewing and rebalancing the portfolio. These decisions have to be based on the analysis of available information so that they reflect the expected performance and risks associated with the investment. Very often the decisions are influenced by behavioral biases in the decision maker, which leads to less than optimal choices being made. Some of the well documented biases that are observed in decision making are
1. Optimism or Confidence Bias outperform the market based on some investing successes. Such winners are more often than not short-term in nature and may be the outcome of chance rather than skill. If investors do not recognize the bias, they will continue to make their decisions based on what they feel is right than on objective information.
2. Familiarity Bias: This bias leads investors to choose what they are comfortable with. This may be asset classes they are familiar with, stocks or sectors that they have greater information about and so on. Investors holding an only real estate portfolio or a stock portfolio concentrated in shares of a particular company or sector are demonstrating this bias. It leads to concentrated portfolios that may be unsuitable for the investor’s requirements and feature higher risk of exposure to the preferred investment. Since other opportunities are avoided, the portfolio is likely to be underperforming.
3. Anchoring: Investors hold on to some information that may no longer be relevant, and make their decisions based on that. New information is labelled as incorrect or irrelevant and ignored in the decision making process. Investors who wait for the ‘right price’ to sell even when new information indicate that the expected price is no longer appropriate , are exhibiting this bias. For example, they may be holding on to losing stocks in expectation of the price regaining levels that are no longer viable given current information, and this impacts the overall portfolio returns.
4. Loss Aversion: The fear of losses leads to inaction. Studies show that the pain of loss is twice as strong as the pleasure they felt at a gain of a similar magnitude. Investors prefer to do nothing despite information and analysis favouring a particular action that in the mind of the investor may lead to a loss. Holding on to losing stocks, avoiding riskier asset classes like equity when there is a lot of information and discussion going around on market volatility are manifestations of this bias. In such situations investors tend to frequently evaluate their portfolio’s performance, and any short-term loss seen in the portfolio makes inaction the preferred strategy.
5. Herd Mentality: This bias is an outcome of uncertainty and a belief that others may have better information, which leads investors to follow the investment choices that others make. Such choices may seem right and even be justified by short-term performance, but often lead to bubbles and crashes. Small investors keep watching other participants for confirmation and then end up entering when the markets are over heated and poised for correction.
6. Recency Bias: The impact of recent events on decision making can be very strong. This applies equally to positive and negative experiences. Investors tend to extrapolate the event into the future and expect a repeat. A bear market or a financial crisis lead people to prefer safe assets. Similarly a bull market make people allocate more than what is advised to risky assets. The recent experience overrides analysis in decision making.
7. Choice Paralysis: The availability of too many options for investment can lead to a situation of not wanting to evaluate and make the decision. Too much of information also leads to a similar outcome on taking action. These are some biases that commonly observed not only in investment decision making. Professional fund managers have systems and processes in place to reduce or negate the effect of such bias. The checks and balances exist from the stage of gathering information, to interpretation of the information and decision making on entry and exits. Individual investors can also reduce the effect of such biases by adopting a few techniques. As far as possible the focus should be on data and what it is saying. Setting in place automated and process-oriented investing and reviewing methods can help biases such as inertia and inaction. Facility such as systematic investing helps here. Over evaluation can be avoided by doing reviews to a schedule. Investing strategies such as value investing, which is contrarian in nature; helps avoid the effect of herd mentality. It is always good to have an adviser the investor can trust who will take a more objective view of the investor’s finances in making decisions and will also help prevent biases from creeping in.