Approaches to investment Decision Making

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 undervalued securities (securities whose intrinsic value exceeds the market price) and selling over valued securities (securities whose intrinsic value is less than the market price). Psychological Approach: 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. Those 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.

Academic Approach: 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 behaviour corresponds to a random walk. This means that successive price changes are independent. As a result, past price behaviour cannot be used to predict future price behaviour. 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).

Eclectic approach: This approach draws upon all the 3 approaches discussed above. The basic rules of this approach are: 1. Fundamental analysis would help us in establishing standards and benchmarks. 2. Technical analysis would help us gauge the current investor mood and the relative strength of demand and supply. 3. The market is neither well ordered nor speculative. The market has imperfections, but reacts reasonably well to the flow of information. Although some securities would be mispriced, there is a positive correlation between risk and return.

Sources of investment information

Your best source of information is your financial adviser. If you have developed an investment plan based on your financial situation, your capacity for risk, and your investment objectives, your advisor is the best person to help you execute your plan. But, to get the right answers, you have to ask the right questions, and that requires attention to several economic indicators. Indicators of economic developments are usually reported by The Financial Post and The Globe & Mail. All major brokerage houses

publish economic forecasts at least annually, and business publications produce economic reports. Mutual fund companies publish newsletters, quarterly and annual reports, and sometimes monthly reports from fund managers. Television programs include Public Television's Nightly Business Report and Wall Street Week. As well, radio programs such as Everett Banning's Moneyworks can be helpful. Economic information is only as reliable as the raw data collected and the credibility of its interpretation. Pay attention to the time period upon which the data are based. After collection, sorting, analyzing, and reporting, some data are weeks or months old. Also, take special note of any corrections to reports previously issued. Coverage is usually greatest when data are first reported, accurate or not, and later corrections are often much closer to the true story. Gross National Product (GNP) deserves watching. It is the total market value of all goods and services purchased for direct use, and which won't require any further production, distribution or processing. An increasing GNP indicates an increase in economic activity, usually more jobs, more energy required, and more factories in need of upgrading. If GNP has been low or negative for a time, an increase may precede a rise in consumer spending on small appliances or clothing. If the GNP continue to rise, more expensive items such as cars, large appliances, or houses may be in demand, as well as raw materials like steel and lumber to make them. But remember, GNP only signals a rise in activity, not that things are actually getting better. When someone is diagnosed with cancer and requires treatment, GNP goes up. When a major source of pollution has to be cleaned up, GNP rises. The Consumer Price Index (CPI) gives an indication of the rate of inflation. It is based on a basket of goods and services that the average consumer might purchase. If the CPI rises quickly, investors may move to hedges against inflation such as natural

resource stocks and precious metals. If the CPI is stagnant or decreasing, it may signal a reduction in interest rates which is good for fixed-income investments such as bonds. Unemployment Rates measure the number of people registered as unemployed, but they don't cover those who have given up looking for work. We all have a sense of the level of unemployment from the news, so the trend is usually more important than the actual level. If unemployment is increasing, there is more worry about job security, and consumers tend to spend less. Government deficits may increase as money is used for job creation or unemployment insurance payments. If unemployment is decreasing, worries about inflation may surface and it's sensible to watch the CPI. Housing Starts and Car Sales are both related to consumer confidence and are fairly accurate because of the ease of collecting data. However, because building a house takes time, housing starts reported today reflect consumer confidence six to 12 months ago. Housing starts bode well for the construction industry, furnishings, large appliances, and plumbing as well as their suppliers and the raw materials to make the products. However, once the figures are published, the growth has already begun and smart investors will have bought their stock six to 12 months ago. Money Supply and Interest Rates are usually related. Money supply is the amount of money in circulation, controlled by the Bank of Canada. Increasing the money supply lowers interest rates, supports economic expansion, and increases the possibility of employment and inflation. Decreasing the money supply does the opposite. There are many other economic indicators that investors can watch but you can have too much information, too. The best strategy is to discuss changes in economic trends with

your investment adviser in order to structure the investment portfolio that is best for you.