The stock market is thronged by investors pursuing diverse investment strategies which may be subsumed under four broad approaches.
1. Fundamental approach
2. Psychological approach
3. Academic approach
4. Eclectic approach
Fundamental Approach: The basic tenets of the fundamental approach, which is perhaps most commonly advocated by investment professionals, are as follows:
1. There is an intrinsic value of a security, which depends upon underlying economic (fundamental) factors. The intrinsic value can be established by a penetrating analysis of the fundamental factors relating to the company, industry, and economy.
2. At any given point of time, there are some securities for which the travailing market price will differ from the intrinsic value. Sooner or later, of course, the market price will fall in line with the intrinsic value.
3. Superior returns can be earned by buying under valued securities (securities whose intrinsic value exceeds the market price) and selling over valued securities (securities whose intrinsic value is less than the market price).
The psychological approach is based on the premise that stock prices are guided by emotion rather than reason. Stock prices are believed to be influenced by the psychological mood of investors. When greed and euphoria sweep the market, prices rise to dizzy heights. On the other hand, when fear and despair envelop the market prices fall to abysmally low levels.
A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield.
Since psychic values appear to be more important than intrinsic values, the psychological approach suggest that it is more profitable to analyze how investors tend to behave as the market is swept by waves of optimism and pessimism which seem to alternate. The psychological approach has been described vividly as the castles in the air theory by some economists.
Hose who subscribe to the psychological approach or the castles in the air theory generally use some form of technical analysis which is concerned with a study of internal market data, with a view to developing trading rules aimed at profit making. The basic premise of technical analysis is that there are certain persistent and recurring patterns of price movements which can be discerned by analyzing market data. Technical analysts use a variety of tools like bar chart, point and figure chart, moving average analysis breadth of market analysis etc.
Over the last five decades or so, the academic community has studied various aspects of the capital market particularly in the advanced countries, with the help of fairly sophisticated methods of investigation. While there are many unresolved issues and controversies stemming from studies pointing in different directions, there appears to be substantial support for the following tenets.
1. Stock markets are reasonably efficient in reacting quickly and rationally to the flow of information. Hence, stock prices reflect intrinsic value fairly well. Put differently,
Market price = Intrinsic value
2. Stock price behavior corresponds to a random walk. This means that successive price changes are independent. As a result, past price behavior cannot be used to predict future price behavior.
3. In the capital market, there is a positive relationship between risk and return. More specifically the expected return from a security is linearly related to its systematic risk (also referred to as its market risk on non-diversifiable risk).