Investment Theory

Investment Theory
Investment Theory

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This article discusses the top seven investing analysis theories. Theory:

Flow of Funds:

Money lubricates the economy and financial system. Investments are money claims based on cash, credit, and savings. Stock and capital markets trade these claims. Investment leads to capital formation, which fuels the production of products and services, income, and economic expansion.

At the micro level, savings flow into investment based on a scientific analysis of market forces — fundamental analysis — economic, industry, and company forces — financial and physical performance of companies analyzed through financial ratios (financial management and management accounting) and technical analysis of market trends based on past behavior.

Market efficiency and random walk:

Market Efficiency and Random Walk Theories explain price generation through perfect information absorption and random, independent price movement. If pricing is determined by supply and demand based on free flow of true and complete information, the market is efficient. Information isn’t free and complete in reality. Price trends require technical analysis and the Dow Theory.

If market absorption and information flows aren’t flawless, share prices may not achieve intrinsic value. Actual share pricing is examined based on earnings potential (EPS), dividend distribution, P/E ratio, and other financial parameters, and a price projection is generated to see if the share is overvalued or underpriced. Investors acquire underpriced shares and sell overvalued shares. If random walk is disproven, markets are inefficient.

Capital Assets Pricing Model:

Following the Markowitz model, the capital market line and efficiency frontier line can be drawn to arrive at an efficient portfolio for each investor. The efficient portfolio minimizes risk or optimizes return for a given amount of risk. Portfolio theory’s risk-return analysis helps build efficient portfolios.

In modern portfolio theory, Beta replaces CAPM’s standard deviation of expected returns to reflect risk. The slope of the capital market line represents Beta, which ties a company’s risk to market risk. ACC and Reliance have aggressive Betas. They’re riskier and pay more than average. ITC and Hindustan Lever are defensive stocks with lower returns and less risk than the market average.

If a company’s risk is the same as the market’s, its risk premium (Beta = 1) equals the market’s. An efficient portfolio can be built utilizing an appropriate Beta that matches investor preferences. Portfolio management is a dynamic process based on portfolio theory that involves regular assessment of scrips purchases and sales, market activities, portfolio revision, etc.

Thus, portfolio theory and management rationalize investor acquisitions and sales. Share price forecasts are based on the company’s financial and physical performance. Market analysis determines when to buy or sell. All of them make up the investment analysis and market operations framework.

Portfolio risk:

Portfolio selection reduces systematic and unsystematic risks. Systematic risk is external to the firm and uncontrollable. Economic conditions, interest rates, inflation, recession, market demand, etc. Interest rate, buying power (inflation), and market hazards are included.

Unsystematic risk is controlled variance in earnings owing to industry, management, consumer preferences, labor, and raw material difficulties, etc. Business, financial, etc. risks. Total risk is the sum of systematic and unsystematic hazards, which is return variability.

For a scientific investment base, the analyst or investor must analyze the market and scrips. For this, he should understand market pricing influences and price formation.

What sets prices? Why is Telco’s share price Rs. 230? Why is Tisco stock $150 today? What’s the price? Should I buy now? Investors and traders should consider these and other questions. Price formation theory is essential. These are stated in clear words below.

Third theory: efficient market

This hypothesis says the market may quickly respond to new economic, industry, and corporate information. Under this view, prices are decided by market forces, which are affected by free, correct, unbiased information. In reality, these conditions are wonderful.

Random Walk Theory

This hypothesis says that previous trends can’t predict share prices. Assuming the market is efficient, all information is quickly absorbed into prices, which move randomly and don’t reoccur. Yesterday’s pricing don’t affect today’s. Prices can go up or down, thus an average investor can’t earn more than average profits except by chance. The prices change in a random manner based upon the flow of information and every combination of shares is as good as any other combination to achieve fair returns.

Trend Walk:

The Trend Walk Theory proposes that investors follow prior trends and buy what others are buying. Trend-setters set the trend, and trend-walkers follow it. He follows the dominant market trend. This behavior is rational because prior trends determine the market. The present is a result of the past, and the market absorbs information imperfectly, thus random movements are illogical and inconsistent with reality.

Daily trend-walkers follow the majority’s market tendency. Contrary to the Random Walk Theory, information flows are often erroneous and biased, and market absorption is poor. Early risers or trend­setters who recognize developments first or are better informed establish market trends and often profit. Trend-walkers are typical investors who may lose money when market trends alter.

CAP Theory:

Under this hypothesis, each security’s return is related to its risk. This risk includes market and company-specific risks. If risk is spread among market securities, company-related hazards are covered, mitigated, or eliminated. Only market-related systematic risk remains in a diversified portfolio. In this concept, alternative portfolios with reduced risk have the same return. This theory disproves the idea that risk equals reward. Normal returns for high-risk scrips are high.

In CAPT, only market risk remains, not corporate risk. The market should be free, with many actors impacted fairly and accurately by demand and supply forces generated by exact and perfect information. The market digests this knowledge and sets fair, competitive pricing. Thus, a share’s price is established by auction, and the market is the best performance; no one can beat it.

This model postulates that firm risk premium and market risk are related by “Beta.”

The following securities valuation equation shows “Beta”:

Ri-Rf=Bi (RM – Rf)

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Ri is the scrip’s appreciation rate (return on it).

Rf = risk-free rate.

Market risk is the average market return. Bi links the market rate premium to the company’s risk premium (Ri – Rf). While (Ri – Rf) is the I scrip risk premium, (RM – Rf) is the market risk premium. These notions are related by the multiplier “Beta”, which measures the company’s risk compared to the market risk.

Portfolio theory

This theory relates to CAP. Companies have various risks under this theory. Any stock market investment carries these risks. Investors are risk-averse. They want a low-risk, high-return portfolio. In portfolio theory, risk is decreased or eliminated by choosing companies with negative covariance, meaning they aren’t dependent on the same economic variables.

So automakers should also make scooters, cycles, etc. In this context, companies must be categorized as having positive or negative covariance (competitive). Diverse industries and firms should be included in a portfolio to lessen risk.

Systematic (market-related) and specific risks exist (company related). Systemic risk reflects individual scrip’s market sequence behavior. Some stocks closely follow the market. “Beta” measures individual stock volatility relative to market behavior.

Beta:

Portfolio management uses Beta to measure systematic risk. Beta quantifies a stock’s fluctuation relative to the market. Beta can be positive or negative depending on whether the individual scrip goes in the same direction as the market or in the opposite way. Beta measures the extent of one scrip’s variance vis-à-vis the market.

Beta is negative if the share price moves against the trend and positive if it does. High-Beta scrips are aggressive, and low-Beta scrips are protective. Aggressive stock portfolios will outperform.

ADVERTISEMENTS: Calculate Betas for all scrips and choose high Betas for a high-return portfolio. Aggressive scrips are dangerous because they outperform the market in uptrend and downtrend and have wide volatility. This security is 50% riskier than the market portfolio if B is 1.5. If B=1, the security’s risk equals the market’s.

How to calculate “Beta”

B is the relative variability of a stock’s return to the market’s return.

Rj=a+Bj +RM

Rj is the return on security j, RM is the market index return, Bj is a risk measure, an is the intercept term, and u is the error term. The equation for Beta can be found in the market model.

If the risk-free rate is 10%, the market return is 15%, and B is 1.5, the security’s projected return is:

Risk free rate + B = 10 + 1.5 (15 – 10) = 10 + 7.5 = 17.5%.

The market rate is 15%, but the asset under consideration yields 17.5% because it’s riskier.

The fundamental school believes shares behave based on company performance and indirectly through industry and economy influences. This method projects the company’s future pricing behavior based on its past behavior. This school also believes share prices converge on fundamental value. The intrinsic value of a company’s shares depends on its future earning potential and development.

The school determines a share’s intrinsic value based on market dynamics and other firm considerations. These factors may be economic, industrial, or company-related. If information flows are flawless and correct, the share price reflects its underlying value. If there are market flaws and incorrect, skewed, or inadequate information flows, the market price and the share’s actual worth will diverge.

The intrinsic value is the individual investor’s perception of the scrip price based on his earnings prediction. The intrinsic value of a scrip is the discounted present value of a company’s future dividends. Market price and inherent value often diverge. Basic school can’t catch emotional components. Technical analysis is required.

Intrinsic and Market Value:

In fundamental analysis, the analyst seeks undervalued or low-priced securities compared to their intrinsic value. Graham & Dodd (Securities Analysis) describe intrinsic value as “value justified by assets, profits, dividends.” These facts affect the company’s earnings. The analyst must forecast future earnings per share and value them by adding discounted dividends or earnings.

All future earnings are discounted to the present, giving its intrinsic worth. Multiply profits rate by industry average P/E ratio. In the case of ABS Plastics, if earnings per share are Rs. 5 and its capitalization rate is expected to be 11, the market price should be around Rs. 55. (11 x 5). The current market price of roughly Rs. 80 indicates overvaluation, which may represent investors’ view of capital appreciation and the psychological and behavioral premium they place on the company’s share.

Shares:

Investors choose undervalued stocks to buy and sell for a profit. To choose a portfolio, an investor must evaluate securities. Undervalued stocks may be growth-oriented, blue-chip, income, cyclical, or defensive.

People choose growth companies or blue chip stocks with expansion ambitions, uninterrupted profits, dividend, and bonus records. Some blue chip stocks may be growth stocks with faster growth rates than the market average.

Risk-averse investors like income stocks. These stocks should have a stable dividend history. Mutual funds, unit trusts, and well-established public firms pay good dividends. Buying undervalued scrips requires serious consideration.

A share is undervalued if its risk is lower than the market’s and its return is higher. To determine if a stock is undervalued, compare its market price to its book value or its P/E ratio to similar ratios in the same industry or the industry average.

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