IAPM/U1 Topic 9 Aim & Approaches of Security Analysis
Aim of Security Analysis
Capital appreciation is concerned with long-term growth. This strategy is most familiar in retirement plans where investments work for many years inside a qualified plan. However, investing for capital appreciation is not limited to qualified retirement accounts. If this is your objective, you are planning to hold the stocks for many years. You are content to let them grow within your portfolio, reinvesting dividends to purchase more shares. A typical strategy employs making regular purchases. You are not very concerned with day-to-day fluctuations, but keep a close eye on the fundamentals of the company for changes that could affect long-term growth.
If your objective is current income, you are most likely interested in stocks that pay a consistent and high dividend. You may also include some top-quality real estate investment trusts (REITs) and highly-rated bonds. All of these products produce current income on a regular basis. Many people who pursue a strategy of current income are retired and use the income for living expenses. Other people take advantage of a lump sum of capital to create an income stream that never touches the principal, yet provides cash for certain current needs (college, for example).
Capital preservation is a strategy you often associate with elderly people who want to make sure they don’t outlive their money. Retired on nearly retired people often use this strategy to hold on the detention has. For this investor, safety is extremely important – even to the extent of giving up return for security. The logic for this safety is clear. If they lose their money through foolish investment and are retired, it is unlike they will get a chance to replace it. Investors who use capital preservation tend to invest in bank CDs, Treasury issues and savings accounts.
The speculator is not a true investor, but a trader who enjoys jumping into and out of stocks as if they were bad shoes. Speculators or traders are interested in quick profits and used advanced trading techniques like shorting stocks, trading on the margin, options and other special equipment. They have no love for the companies they trade and, in fact may not know much about them at all other than the stock is volatile and ripe for a quick profit. Speculators keep their eyes open for a quick profit situation and hope to trade in and out without much thought about the underlying companies. Many people try speculating in the stock market with the misguided goal of getting rich. It doesn’t work that way. If you want to try your hand, make sure you are using money you can afford to lose. It’s easy to get addicted, so make sure you understand the real possibilities of losing your investment.
The secondary objectives are tax minimization and Marketability or liquidity.
An investor may pursue certain investments in order to adopt tax minimization as part of his or her investment strategy. A highly-paid executive, for example, may want to seek investments with favorable tax treatment in order to lessen his or her overall income tax burden. Making contributions to an IRA or other tax-sheltered retirement plan can be an effective tax minimization strategy.
Many of the investments we have discussed are reasonably illiquid, which means they cannot be immediately sold and easily converted into cash. Achieving a degree ofliquidity, however, requires the sacrifice of a certain level of income or potential for capital gains.
Common stock is often considered the most liquid of investments, since it can usually be sold within a day or two of the decision to sell. Bonds can also be fairly marketable, but some bonds are highly illiquid, or non-tradable, possessing a fixed term. Similarly, money market instruments may only be redeemable at the precise date at which the fixed term ends. If an investor seeks liquidity, money market assets and non-tradable bonds aren’t likely to be held in his or her portfolio.
There are mainly three alternative approaches to security analysis, namely fundamental analysis, technical analysis and efficient market theory.
1. Fundamental Analysis
The fundamental analysis allows for selection of securities of different sectors of the economy that appear to offer profitable opportunities. The security analysis will help to establish what type of investment should be undertaken among various alternatives i.e. real estate, bonds, debentures, equity shares, fixed deposit, gold, jewellery etc. Neither all industries grow at same rate nor do all companies. The growth rates of a company depend basically on its ability to satisfy human desires through production of goods or performance is important to analyze nation economy. It is very important to predict the course of national economy because economic activity substantially affects corporate profits, investors’ attitudes, expectations and ultimately security price.
According to this approach, the share price of a company is determined by these fundamental factors. The fundamental works out the compares this intrinsic value of a security based on its fundamental; them compares this intrinsic value, the share is said to be overpriced and vice versa. The mispricing security provides an opportunity to the investor to those securities, which are under priced and sell those securities, which are overpriced. It is believed that the market will correct notable cases of mispricing in future. The prices of undervalued shares will increase and those of overvalued will decline. Fundamental analysis helps to identify fundamentally strong companies whose shares are worthy to be included in the investor’s portfolio.
2. Technical Analysis
The second alternative of security analysis is technical analysis. The technical analysis is the study of market action for the purpose of forecasting future price trends. The term market action includes the three principal sources of information available to the technician – price, value, and interest. Technical Analysis can be frequently used to supplement the fundamental analysis. It discards the fundamental approach to intrinsic value. Changes in price movements represent shifts in supply and demand position. Technical Analysis is useful in timing a buy or sells order. The technical analysis does not claim 100% of success in predictions. It helps to improve the knowledge of the probability of price behavior and provides for investment. The current market price is compared with the future predicted price to determine the extent of mispricing. Technical analysis is an approach, which concentrates on price movements and ignores the fundamentals of the shares.
3. Efficient Market Theory
A more recent approach to security analysis is the efficient market hypothesis/theory. According to this school of thought, the financial market is efficient in pricing securities. The efficient market hypothesis holds that market prices instantaneously and fully reflect all relevant available information. It means that the market prices of securities will always equal its intrinsic value. As a result, fundamental analysis, which tries to identify undervalued or overvalued securities, is said to be a useless exercise.
Efficient market hypothesis is direct repudiation of both fundamental analysis and technical analysis. An investor can’t consistently earn abnormal return by undertaking fundamental analysis or technical analysis. According to efficient market hypothesis it is possible for an investor to earn normal return by randomly choosing securities of a given risk level.