Millions of Americans invest their hard-earned dollars in the stock market with the objective of meeting their future financial needs. There are many different approaches to investing in stocks, each of them designed to reduce some of the risk of investing while increasing returns. Every strategy has its advantages and disadvantages. You should try to find the approach best suited to your own financial situation and goals.
Investing strategies can be broken down into two broad categories: technical analysis and fundamental analysis. They are as different as night and day, but each camp has its followers and its critics.
Technical analysis is an attempt to use price charts and other mathematical indicators in order to predict future price movements of a stock. The method doesn’t look at any outside factors, such as the company’s financial statements or the overall economic outlook. It’s strictly by the charts. Market technicians believe that the market price of a security reflects all known information about that security.
The downside of technical analysis is that it’s very, well, technical. Although there are some excellent software programs specifically for technical analysis, the learning curve to just get started using these techniques can be formidable. Another disadvantage of technical analysis is that it requires you to actively follow current and potential holdings, reviewing charts and indicators each day or week. This means being glued to your computer screen for hours at a session, and can require ample number-crunching skills. Finally, technical analysis is often a short-term strategy, requiring you to make frequent trades and to pay the commissions and short-term capital gains taxes that result (that is, if you have any gains!).
Opponents of technical analysis believe there is no cause-and-effect relationship between a stock’s past price performance and its future performance, and that relying on chart patterns is a bit like expecting it to rain on June 21st if June 10th is sunny, just because that’s what happened last year.
Market timers try to determine when to buy or sell a particular security, or to get in or out of the market entirely. Market-timing systems usually examine reams of data and try to find the best signals indicating when to buy and when to sell. Unfortunately, short of gazing into a crystal ball, there is no reliable way of knowing when the market will turn in any direction, at least in the short term. In the market correction of 1987, only a handful of the population of well-informed experts on Wall Street were able to predict the impending downturn.
Considering the Fundamentals
On the opposite side of the coin from technical analysis is fundamental analysis. Fundamental analysis can be described as the study and purchase of companies, rather than stocks. Factors such as a company’s growth rates, balance sheet, and quality of management are analyzed to determine the true value of a security. Fundamentalists aren’t concerned with price patterns on a chart, but with indicators of a company’s underlying financial strength.
When you go shopping for a new car, don’t you try to buy the best car you can for the best price? You want a vehicle that will run for a long time without breaking down, at least as long as you need. You don’t want to have to think about whether or not you’ll make it work each morning—you just want your car to get you there. You want a car that will require as little maintenance as possible, not one that needs a tune-up every few thousand miles. You don’t want to pay too much for your new car, though. If you can get a well-made car that fits all your needs, and buy it at a reasonable price, you’ll be one happy car-owner.
Investing in common stocks isn’t much different. You can buy the stock of a high-quality company at a good price, put it away in your portfolio, and not worry about it except during your occasional portfolio checkup. Hopefully, over the long term, that company can grow and see its stock price appreciate as a result, and your portfolio can become all the richer. Since you’re not trading frequently, you won’t have to worry as much about taxes eroding your capital, or paying lots in commissions.
Just like shopping for a car, however, you need to do your homework first in order to make sure you’re getting a good deal on a good company. By investing in quality companies at reasonable prices, you can limit your risks and increase your returns.
Sounds like a reasonable approach to investing in the stock market, right? You wouldn’t buy a car based on a chart of all the car prices at all the dealers in town, without any identification of what make or model each was-so why buy stocks for your portfolio that way?
There are many related strategies investors use to select stocks within the spectrum of fundamental analysis. Value investors look at how much a company is worth based on the worth of all its assets, and at how well the company uses its assets to grow its business. If the company’s stock price doesn’t reflect the full value of its assets, the stock is considered undervalued. If the stock price increases to reflect the company’s underlying worth, perhaps over a period of years, the shareholder is rewarded. Warren Buffet is a well-known value investor, and his company, Berkshire Hathaway, has grown as a result of its investments in companies like Geico, Coca-Cola, and The Washington Post.
Growth investors look at how quickly companies have been able to grow their sales and earnings in the past, and how that growth is likely to continue in the future. Then they look at the current price and determine if it reflects the potential future growth of the company’s businesses. By buying companies that are growing faster than other similar companies, these investors hope to see their investment grow over the years. Peter Lynch primarily used a growth investing strategy while he managed the Fidelity Magellan fund, turning in the all-time best historical performance of any fund.
Many long-term investors combine aspects of growth and value investing in their personal strategy, looking to identify undervalued stocks that have the potential to grow in the years ahead. By using techniques of fundamental analysis, you can build a portfolio of stocks to hold for the long-term, allowing the stocks to grow over the years. In addition, you can use dollar-cost averaging to add more shares to your portfolio on a regular basis.