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 reaching 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).
The eclectic approach draws on all the three different approaches discussed above. The basic premises of the eclectic approach are as follows:
1) Fundamental analysis is helpful in establishing basic standards and benchmarks. However, since there are uncertainties associated with fundamental analysis, exclusive reliance on fundamental analysis should be avoided. Equally important, excessive refinement and complexity in fundamental analysis must be viewed with caution.
2) Technical analysis is useful in broadly gauging the prevailing mood of investors and the relative strengths of supply and demand forces. However, since the mood of investors can vary unpredictably excessive reliance on technical indicators can be hazardous. More important, complicated technical systems should ordinarily be regarded as suspect because the often represent figments of imagination rather than tools of proven usefulness.
3) The market is neither as well ordered as the academic approach suggest, nor as speculative as the psychological approach indicates. While it is characterized by some in efficiencies and imperfections, it seems to react reasonably efficiently and rationally to the flow of information. Likewise, despite many instances of mis-priced securities, there appears to be a fairly strong correlation between risk and return.
The operational implications of the eclectic approach are as follows:
1) Conduct fundamental analysis to establish certain value ‘anchors’
2) Do technical analysis to assess the state of the market psychology
3) Combine fundamental and technical analyses to determine which securities are worth, buying worth holding and worth disposing of
4) Respect market prices and do not show excessive zeal in beating the market.
5) Accept the fact that the search for a higher level of return often necessitates the assumption of a higher level of risk.
As a virtue, patience is strangely distributed among investors. Young investors; within all the time in the world to reap the benefits of patient and diligent investing, seem to be the most impatient. They look for instantaneous results and often check prices on a daily basis. Old investors, on the other hand, display a high degree of patience even though they have little chance of enjoying the fruits of patience.
Whatever may be the temperamental basis for the young to be impatient in the field of investment there are compelling reasons for cultivating patience. The game of investment requires patience and diligence. In the short run, the factor of luck may be important because of randomness in stock price behavior, which may be likened to the Brownian motion on physics. In the long run, however investor performance depends daily on patience and diligence, because the random movements tend to even out.
Rudyard Kipling believed an important virtue for becoming a mature adult is to keep your head when all around you are losing theirs. The ability to maintain composure is also a virtue required to be successful investor. Conscious of this, as an investor you should try to (a) understand your own impulses and instincts towards greed and fear; (b) surmount these emotions that can wrap your judgment and (c) capitalize on the greed and fear of other investors.
While the above advice sounds simple, it is difficult to practice. Greed and fear are far more powerful forces than reason in influencing investment decisions. Rarely do you come across an investor who is immune to these emotions that are so pervasive in the marketplace. Greed and fear tend to be insidiously contagious. In your attempt to overcome them, you may find the following suggestions helpful.
1) Maintain a certain distance from the market place. Your vulnerability to the contagious influences of greed and fear diminishes, if your contact with others caught in the whirlpool of market psychology decreases.
2) Rely more on hard members and loess on judgment (which is more prone to be influenced by the emotions of greed and fear). This is the advice given by Benjamin Graham, widely regarded as the father of security analysis.