Modules for Traders
Introduction to Technical Analysis
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Techniques of Investment Analysis
Meet 30-year old Sanjay. He’s interested in purchasing a plot of land. However, since he has never done this before, Sanjay wants to cover all his bases and be extra sure that he’s making the right decision. Here what Sanjay’s been doing before getting a plot in his name.
- He looked at the layout of the land
- He checked out how safe the area was from floods and other natural calamities
- He analysed if the land was suited for agriculture
- He looked into the kind of houses that would be buildable on the land
- He noted down how the price of the land has appreciated over the past few years.
- He asked around about how much the plot’s value would increase in the coming years.
What Sanjay has been doing is essentially an investment analysis. But financially speaking, what does this term mean? Come, let’s find out.
What is investment analysis?
Investment analysis is a collective term for the many different strategies used to evaluate investments. It includes various practices and methods like analysing economic trends, charting past prices and returns, speculating how the future performance of an investment will be, determining the risks, potential and price movements of various investments, and identifying the investments that suit your needs as an investor. These are only some of the many different techniques of financial analysis available for investors.
What Sanjay did – that’s just one way to go about analysing an investment. There are actually a number of ways through which you can figure out various investment-related moves. Here’s a preview of what investment analysis can help you do.
- It can help you figure out if you should invest in an asset.
- It lets you determine how much to invest in an asset.
- It tells you when you may need to divest from a specific asset.
- It even throws light on the potential returns from an investment.
Now, while Sanjay went about performing investment analysis on his own, there are some investment analysis techniques that give you access to expert help. Among these, two popular options include algorithmic trading and outsourcing your investment decisions.
Let’s look into these two different techniques of financial analysis now.
Say you run a business of your own. At the end of each business day, you sit down to manually note down and add up all the sales that you made that day. If around 200 customers drop in each day on an average, that means you’ll have to add at least 200 numbers each day. Doing it manually can take a long time.
Now say you hire a young tech-savvy apprentice. This guy sees you working at the numbers at the end of each day, and he decides to make your job easier. He feeds in the data into a spreadsheet and lets the programme do the math for you. Now, your end-of-the-day task, which earlier took around one hour to complete, gets over in a jiffy.
Algorithmic trading is also something like that. Also known as automated trading, algo trading, or black-box trading, it is the technique of using programmed algorithms to place trade orders at speeds that are manually not possible. Sounds interesting, right?
Let’s look at a simple example for an automated trading command.
- Buy 100,000 shares of ICICI Bank if the price falls below Rs. 300.
- After that, for every 0.1% increase in the price beyond Rs. 300, buy 100 shares.
- And for every 0.1% decrease in the price below Rs. 300, sell 100 shares.
Now, to carry out this command manually, you’ll need to constantly keep track of the price movements and calculate whether any increase of decrease is 0.1% or not. But with algorithmic trading, the programme does the investment analysis for you at every step, and invests or divests as needed.
Outsourcing your investment decisions
If you’re unsure about doing your investment analysis yourself, you can outsource it to a professional analyst or a portfolio manager. These experts take cognizance of your investor profile and analyse various investment options to identify the assets that are well-suited for your risk appetite.
It makes sense to outsource investment research to experts like analysts and portfolio managers because they have access to a number of resources that you may not really be able to procure. Or, even if you do get your hands on those resources, it may be difficult to decipher them without the professional expertise that portfolio managers and investment analysts possess.
Fundamental analysis and technical analysis
Being the two most important investment analysis techniques, fundamental analysis and technical analysis find a mention in any discussion about analysing investments. We went into the details of fundamental analysis in an earlier module. And we even touched upon technical analysis, although very briefly.
Let’s take an example to see how these two techniques are different.
Remember Sanjay from earlier? He wanted to purchase a plot of land, isn’t it? Here are two possible scenarios regarding how he goes about this.
- Sanjay personally visits each plot of land within 10 kilometres from his place and takes a look around.
- He finds out more details about the profitability of each plot.
- He looks at the quality of the soil.
- He makes plans about the possible uses he could put each plot of land to.
- Finally, he decides on a plot of land and purchases it.
In this case, Sanjay knows all the details about the plot he bought, because he performed adequate research. But is that the best plot for him? There’s no guarantee of that, because he only checked out plots within a 10-kilometre section. What if there's a plot some 20 kilometres away that’s a much better investment option?
Well, if there is, then Sanjay would have lost that opportunity, simply because performing an individual analysis on each plot of land within a 20-kilometre section is not practically possible. In other words, while Sanjay’s technique of analysis in this scenario is thorough, it’s not very scalable.
Here, let’s say Sanjay adopts a different approach entirely. Instead of paying a visit to each plot of land, he simply checks out an available plot in the fastest developing part of the city. In all likelihood, the future prospects for a plot of land in such an area are very favourable. By adopting this strategy and going where the market is moving fastest, the chances are very high that Sanjay invested in one of the best plots of land in the city.
Unlike his earlier strategy, this method is more scalable. It even allows Sanjay to access plots that are much further than 10 kilometres. However, there’s also a downside. By simply going where the most action is, there’s no guarantee that Sanjay made the right choice. After all, the crowd could be wrong.
So, now that we’ve seen these scenarios, you’ve probably recognized that scenario 1 has many similarities with fundamental analysis, while scenario 2 is similar to technical analysis. Both fundamental and technical analysis are different techniques of financial analysis that are very useful.
In the chapters of our earlier module, we saw how fundamental analysis focuses on researching the various qualitative and quantitative factors that affect a company’s stock to identify its intrinsic value. Technical analysis, on the other hand, focuses on studying historical trends to determine the possible future trends of a stock’s price.
- Bottom Up
Bottom-up research evaluates individual stocks based on their characteristics. These qualities include, for example, pricing power, managerial expertise, and value. However, while determining asset allocations, this investment research approach does not include market or economic cycles. Instead, regardless of the situation of the economy or market, this strategy looks at the finest firms and stocks. In other words, instead of looking at the economy as a whole, bottom-up analysis takes a microeconomic or small-scale approach.
- Top Down
Before making a more precise investment choice, top-down research analyzes economic, market, and industry trends. Assume an analyst examines several sectors and discovers that technology outperforms financials. As a consequence, people may choose to put more money into financials rather than technology in their portfolio. They'll next look for the banking sector's best-performing firms. In contrast to a bottom-up examination, an investor may discover compelling reasons to acquire and invest a considerable amount of cash in a single technology stock. Even if the industry's general prognosis is bleak, the investor may do so.
Types of Investment Analysis
There are four major types of investment analysis. Each of these techniques works best for different end goals. Let’s take a closer look at these types of investment analysis, so you can get a better idea of which type of analysis to use when.
1. The bottom-up approach
The bottom-up approach is a kind of investment analysis that focuses more on the company and the stock in question, and less on the overall market. In other words, it involves studying how the company fares rather than analysing the economic and market conditions. Here, you evaluate the company and its stock, and study its strengths and merits.
You look at aspects like the following areas.
- The company’s valuation
- The competence of its management
- The pricing power of the stock
- Any other unique attributes of that company
This may seem like a narrow approach, but it helps inventors understand a company better and evaluate if it makes for a worthy investment option. In other words, it helps them make the right investment decisions. It is more microeconomic and small-scale, and it is also easy for beginners to get a grasp on.
2. The top-down approach
The top-down approach is the opposite of the bottom-up approach. Here, you need to begin by first analysing the economy at large. Then, you take a closer look at the industry and the sector in which the company you’re interested in operates. This gives you a good idea of how the economy as a whole is headed, and also how that specific industry’s foreseeable future looks.
In the top-down approach, you take a look at these areas.
- Economic cycles
- Industry trends
- Sector analysis
Once you identify the sectors that are performing well, you can choose the top companies in that sector to invest in. This is a broader approach than the bottom-up analysis technique. But it takes more research and understanding of the market, so it’s better suited for seasoned investors.
3. Fundamental analysis
Fundamental analysis is the most preferred technique for investors who are looking to invest in the market over the long term. As the name indicates, fundamental analysis involves looking into the basics of a company to assess its financial strength. The end goal is to identify the intrinsic value of a stock, so you can compare it with the current market price and determine if the stock is overvalued or undervalued.
Typically, overvalued stocks are sold, while undervalued stocks are bought.
In fundamental analysis, you make use of the information in the following documents to understand the nature of business and the financial position of a company.
- Annual reports
- Profit and loss statement
- Balance sheet
- Cash flow statement
In addition to this, you also need to look at metrics like financial ratios and perform the valuation technique. You will find the details of this as you proceed across the various modules in Smart Money. Fundamental analysis takes time, but since it is best suited for long-term investment, it is advisable to analyse the stock thoroughly before making an investment in that security.
4. Technical analysis
Technical analysis, unlike fundamental analysis, is better suited for short-term investment decisions. In other words, it is essential for traders who are looking to profit from short-term market movements. Technical analysis involves looking at the past price movements of a stock and identifying potential patterns there, which could help predict the future price movements of a stock’s price.
Technical analysts make use of resources like the following.
- Analytical charting tools
- Trading signals
- Past price movements
Based on the predictions for future price movements, traders take decisions regarding buying, selling or holding a stock.
So, to sum up the different investment analysis techniques, the bottom-up approach is suited for beginners, the top-down approach for seasoned investors, fundamental analysis for long-term investors, and technical analysis for traders.
In the next chapter, we’ll get into the details of what technical analysis is all about. We’ll see what the fundamental theory of technical analysis is, and then, in the later chapters in this module, we’ll also see the kinds of charts used in technical analysis. Keep reading to learn about this investment analysis technique.
A quick recap
- Investment analysis is a collective term for the many different strategies used to evaluate investments.
- It includes various practices and methods like analysing economic trends, charting past prices and returns, speculating how the future performance of an investment will be, determining the risks, potential and price movements of various investments, and identifying the investments that suit your needs as an investor.
- Algorithmic trading, also known as automated trading or black-box trading, is the technique of using programmed algorithms to place trade orders at speeds that are manually not possible.
- If you’re unsure about doing your investment analysis yourself, you can outsource it to a professional analyst or a portfolio manager.
- Fundamental analysis and technical analysis are the two most important investment analysis techniques.