Friday, November 28, 2014

Approaches to Securities Selection

Once an appropriate allocation between different investment types (for example, stocks, bonds and real estate) has been determined, individual securities (or mutual funds) must be selected within each investment type.

There are two basic approaches to individual security selection:

1.   Top-down

2.   Bottom-up 

In a top-down approach the analyst examines the overall economy and market and selects sectors (for example, Services or Technology) that are expected to perform well in the current market conditions. Individual companies are then selected within each sector based upon desired characteristics.

In a bottom-up approach the analyst first identifies individual companies with desired characteristics and then examines the prospects for those companies given current economic and market conditions.

Regardless of which approach is taken it is important that the economy, market and industry conditions are considered when making the decision to invest in individual securities of any type.

In evaluating individual securities there are also two main approaches:

1.   Fundamental Analysis

Fundamental analysis seeks to identify the fundamental economic and political factors that determine a commodity’s price.It is basically an analysis of the (current and future) demand for and supply of a commodity to determine if

·         a price change is imminent, and

·         in which direction and by how much prices are expected to change.

This approach requires

·         gathering substantial amounts of economic data and political intelligence,

·         assessing the expectations of market participants, and

·         analyzing these information to predict futures price movement

Technical analysis involves a study of past price and volume data to discern underlying trends for a security or market. The price of any asset is partly a function of supply and demand factors. If demand exceeds supply the price should rise. Conversely if supply exceeds demand the price should fall. The underlying supply and demand as well as the behavior of all investors is reflected in charts of price and volume data.

A technical analyst examines these charts to determine if the current trend is expected to continue or to reverse. Technical analysis can be useful in evaluating individual securities, industries and the market as a whole.

Often these two techniques are viewed as mutually exclusive (some people follow one but not the other). Another view is that the approaches are complimentary, a company may look great fundamentally but technical analysis may indicate it is not the best time to buy.