In finance, an investment strategy is a set of rules, behaviors or procedures, designed to guide an investor's selection of an investment portfolio. Usually the strategy will be designed around the investor's risk-return tradeoff: some investors will prefer to maximize expected returns by investing in risky assets, others will prefer to minimize risk, but most will select a strategy somewhere in between.
Passive strategies are often used to minimize transaction costs, and active strategies such as market timing are an attempt to maximize returns.
One of the better known investment strategies is buy and hold. Buy and hold is a long term investment strategy, based on the concept that in the long run equity markets give a good rate of return despite periods of volatility or decline. A purely passive variant of this strategy is indexing where an investor buys a small proportion of all the shares in a market index such as the S&P 500, or more likely, in a mutual fund called an index fund or an exchange-traded fund (ETF).
This viewpoint also holds that market timing, that one can enter the market on the lows and sell on the highs, does not work or does not work for small investors, so it is better to simply buy and hold. The smaller, retail investor more typically uses the buy and hold investment strategy in real estate investment where the holding period is typically the lifespan of their mortgage.
Trading strategy
In finance, a trading strategy (see also trading system) is a predefined set of rules for making trading decisions.
Traders, investment firms and fund managers use a trading strategy to help make wiser investment decisions and help eliminate the emotional aspect of trading. A trading strategy is governed by a set of rules that do not deviate. Emotional bias is eliminated because the systems operate within the parameters known by the trader. The parameters can be trusted based on historical analysis (backtesting) and real world market studies (forward testing), so that the trader can have confidence in the strategy and its operating characteristics.
Executing strategies
A trading strategy can be executed by a trader (manually) or automated (by computer). Manual trading requires a great deal of skill and discipline. It is tempting for the trader to deviate from the strategy, which usually reduces its performance.
An automated trading strategy wraps trading formulas into automated order and execution systems. Advanced computer modeling techniques, combined with electronic access to world market data and information, enable traders using a trading strategy to have a unique market vantage point. A trading strategy can automate all or part of your investment portfolio. Computer trading models can be adjusted for either conservative or aggressive trading styles.
Technical analysis
In finance, technical analysis is a security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume
Technical analysts seek to identify price patterns and trends in financial markets and attempt to exploit those patterns. While technicians use various methods and tools, the study of price charts is primary.
Technicians especially search for archetypal patterns, such as the well-known head and shoulders or double top reversal patterns, study indicators such as moving averages, and look for forms such as lines of support, resistance, channels, and more obscure formations such as flags, pennants, balance days and cup and handle patterns.
Technical analysts also extensively use indicators, which are typically mathematical transformations of price or volume. These indicators are used to help determine whether an asset is trending, and if it is, its price direction. Technicians also look for relationships between price, volume and, in the case of futures, open interest. Examples include the relative strength index, and MACD. Other avenues of study include correlations between changes in options (implied volatility) and put/call ratios with price. Other technicians include sentiment indicators, such as Put/Call ratios and Implied Volatility in their analysis.
Technicians seek to forecast price movements such that large gains from successful trades exceed more numerous but smaller losing trades, producing positive returns in the long run through proper risk control and money management.
There are several schools of technical analysis. Adherents of different schools (for example, candlestick charting, Dow Theory, and Elliott wave theory) may ignore the other approaches, yet many traders combine elements from more than one school. Some technical analysts use subjective judgment to decide which pattern a particular instrument reflects at a given time, and what the interpretation of that pattern should be. Some technical analysts also employ a strictly mechanical or systematic approach to pattern identification and interpretation.
Technical analysis is frequently contrasted with fundamental analysis, the study of economic factors that influence prices in financial markets. Technical analysis holds that prices already reflect all such influences before investors are aware of them, hence the study of price action alone. Some traders use technical or fundamental analysis exclusively, while others use both types to make trading decisions.
Users of technical analysis are most often called technicians or market technicians. Some prefer the term technical market analyst or simply market analyst. An older term, chartist, is sometimes used, but as the discipline has expanded and modernized the use of the term chartist has become less popular.
Characteristics
Technical analysis employs models and trading rules based on price and volume transformations, such as the relative strength index, moving averages, regressions, inter-market and intra-market price correlations, cycles or, classically, through recognition of chart patterns.
Technical analysis stands in contrast to the fundamental analysis approach to security and stock analysis. Technical analysis "ignores" the actual nature of the company, market, currency or commodity and is based solely on "the charts," that is to say price and volume information, whereas fundamental analysis does look at the actual facts of the company, market, currency or commodity. For example, any large brokerage, trading group, or financial institution will typically have both a technical analysis and fundamental analysis team.
Technical analysis is widely used among traders and financial professionals, and is very often used by active day traders, market makers, and pit traders. In the 1960s and 1970s it was widely dismissed by academics. In a recent review, Irwin and Park reported that 56 of 95 modern studies found it produces positive results, but noted that many of the positive results were rendered dubious by issues such as data snooping so that the evidence in support of technical analysis was inconclusive; it is still considered by many academics to be pseudoscience. Academics such as Eugene Fama say the evidence for technical analysis is sparse and is inconsistent with the weak form of the efficient market hypothesis. Users hold that even if technical analysis cannot predict the future, it helps to identify trading opportunities.
In the foreign exchange markets, its use may be more widespread than fundamental analysis. While some isolated studies have indicated that technical trading rules might lead to consistent returns in the period prior to 1987, most academic work has focused on the nature of the anomalous position of the foreign exchange market. It is speculated that this anomaly is due to central bank intervention. Recent research suggests that combining various trading signals into a Combined Signal Approach may be able to increase profitability and reduce dependence on any single rule.
Market action discounts everything
Based on the premise that all relevant information is already reflected by prices, pure technical analysts believe it is redundant to do fundamental analysis – they say news and news events do not significantly influence price, and cite supporting research such as the study by Cutler, Poterba, and Summers titled "What Moves Stock Prices?"
On most of the sizable return days [large market moves]...the information that the press cites as the cause of the market move is not particularly important. Press reports on adjacent days also fail to reveal any convincing accounts of why future profits or discount rates might have changed. Our inability to identify the fundamental shocks that accounted for these significant market moves is difficult to reconcile with the view that such shocks account for most of the variation in stock returns.
Fundamental analysis
Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and management. When analyzing a stock, futures contract, or currency using fundamental analysis there are two basic approaches one can use; bottom up analysis and top down analysis. The term is used to distinguish such analysis from other types of investment analysis, such as quantitative analysis and technical analysis.
Fundamental analysis is performed on historical and present data, but with the goal of making financial forecasts. There are several possible objectives:
to conduct a company stock valuation and predict its probable price evolution,
to make a projection on its business performance,
to evaluate its management and make internal business decisions,
to calculate its credit risk.
Two analytical models
When the objective of the analysis is to determine what stock to buy and at what price, there are two basic methodologies
Fundamental analysis maintains that markets may misprice a security in the short run but that the correct price will eventually be reached. Profits can be made by trading the mispriced security and then waiting for the market to recognize its "mistake" and reprice the security.
Technical analysis maintains that all information is reflected already in the stock price. Trends are your friend and sentiment changes predate and predict trend changes. Investors' emotional responses to price movements lead to recognizable price chart patterns. Technical analysis does not care what the 'value' of a stock is. Their price predictions are only extrapolations from historical price patterns.
Investors can use any or all of these different but somewhat complementary methods for stock picking. For example many fundamental investors use technicals for deciding entry and exit points. Many technical investors use fundamentals to limit their universe of possible stock to 'good' companies.
The choice of stock analysis is determined by the investor's belief in the different paradigms for "how the stock market works". See the discussions at efficient-market hypothesis, random walk hypothesis, capital asset pricing model, Fed model Theory of Equity Valuation, Market-based valuation, and Behavioral finance.
Fundamental analysis includes
1. Economic analysis
2. Industry analysis
3. Company analysis
On the basis of these three analyses the intrinsic value of the shares are determined. This is considered as the true value of the share. If the intrinsic value is higher than the market price it is recommended to buy the share . If it is equal to market price hold the share and if it is less than the market price sell the shares.
Buy and hold
Buy and hold is a long term investment strategy based on the view that in the long run financial markets give a good rate of return despite periods of volatility or decline. This viewpoint also holds that short term market timing, i.e. the concept that one can enter the market on the lows and sell on the highs, does not work for small, or unsophisticated, investors so it is better to simply buy and hold.
The antithesis of buy and hold is the concept of day trading in which money can be made in the short term if an individual tries to short on the peaks, and buy on the lows with greater money coming with greater volatility.
One of the strongest arguments for the buy and hold strategy is the efficient-market hypothesis (EMH): If every security is fairly valued at all times, then there is really no point to trade. Some take the buy and hold strategy to an extreme, advocating that you should never sell a security unless you need the money.
Others have advocated buy and hold on purely cost-based grounds, without resort to the EMH. Costs such as brokerage and bid/offer spread are incurred on all transactions, and buy-and-hold involves the fewest transactions for a given amount invested in the market, all other things being equal. Warren Buffett is an example of a buy and hold advocate who has rejected the EMH in his writings, and has built his fortune by investing in companies at times when they were undervalued. Some may argue that Warren Buffet is a long term market timer.
Liability-driven investment strategy
The liability-driven investment strategy (LDI) is an investment strategy of a company based on its risk tolerance, the company's ethics and the target return. The target return is usually linked to an index or combination of indices of the sector or any other like S&P 500. This is called the benchmark-driven investment strategy.
Especially in the long-term investments, like pension fund, the benchmark-driven is no longer appreciated. Now the buzzword is "liability-driven investment". The investment target of the fund is no longer linked to any external index, but to the liability of the fund, which is evaluated by the actuaries. In case of pension fund, it will be the present value of the benefits payable to the employees and pensioners, attached with a probability of those payments made.
LDI in Pension Funds
A pension fund following an LDI focuses on the pension-fund assets in the context of the promises made to employees and pensioners (known as liabilities). This is in contrast to an approach which focuses purely on the asset side of the pension fund balance sheet. Typical LDI strategies involve hedging, in whole or in part, the fund's exposure to changes in interest rates and inflation. These risks can eat into a pension scheme's ability to keep their promises to members. Historically, bonds were used as a partial hedge for these interest rate risks but the recent growth in LDI has focused on using swaps and other derivatives. These offer significant additional flexibility and capital efficiency compared to bonds.
LDI investment strategies have come to prominence in the UK as a result of changes in the regulatory and accounting framework. IFRS17 (International Financial Reporting Standards) requires that UK companies post the funding position of a pension fund on the corporate sponsor's balance sheet. In the US the introduction of FAS158 (Financial Accounting Standards Board) has created a similar requirement.
Market timing
Market timing is the strategy of making buy or sell decisions of financial assets (often stocks) by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis. This is an investment strategy based on the outlook for an aggregate market, rather than for a particular financial asset.
Moving average
Market timing often looks at various moving averages. Popular are the 50- and 200-day moving averages. Some people consider that if the market has gone above the 50- or 200-day average that should be considered "bullish". The market timers then predict that the trend will, more likely than not, continue in the future. Others say, "nobody knows," and that world economies and stock markets are of such complexity that market timing strategies are unlikely to be more profitable than buy-and-hold strategies.
Differing views on the viability of market timing
Whether market timing is ever a viable investment strategy is controversial. Some may consider market timing to be a form of gambling based on pure chance because they do not believe in undervalued or overvalued markets. The efficient-market hypothesis claims that financial prices always exhibit random walk behavior and thus cannot be predicted with consistency.
Some consider market timing to be sensible in certain situations, such as an apparent bubble. However, because the economy is a complex system that contains many factors, even at times of significant market optimism or pessimism, it remains difficult, if not impossible, to pre-determine the local maximum or minimum of future prices with any precision; a so-called bubble can last for many years before prices collapse. Likewise, a crash can persist for extended periods; stocks that appear to be "cheap" at a glance can often become much cheaper afterwards before either rebounding at some time in the future or heading toward bankruptcy.
Proponents of market timing counter that market timing is just another name for trading. They argue that "attempting to predict future market price movements" is what all traders do, regardless of whether they trade individual stocks or collections of stocks, aka, mutual funds. Thus if market timing is not a viable investment strategy, the proponents say, then neither is any of the trading on the various stock exchanges. Those who disagree with this view usually advocate a buy-and-hold strategy with periodic "rebalancing". But what is this rebalancing if not a point-in-time decision to react to the movements in the market?
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