Your investment strategy deals with the overall, long-term guidelines that you set up and implement in an attempt to ensure success in meeting your financial goals. Most strategies used to invest in the stock market fall into three general categories: fundamental analysis, technical analysis, or buy and hold the market. Let's examine each technique.
The fundamental analysis approach is primarily concerned with value; it examines factors that determine a company's expected future earnings and dividends as well as the continued dependability of those earnings and dividends. It then attempts to put a value on the stock accordingly. Therefore, an investor who uses this approach seeks out stocks that are a good value; in other words, stocks that are priced low relative to their perceived value. The assumption is that the stock market will later recognize the value of the stock and its price will consequently increase.
The investor who uses technical analysis attempts to predict the future price of a stock or the future direction of the market based on past price and trading volume changes. This approach assumes that stock prices and the stock market follow discernible patterns, and if the beginning of a pattern can be identified then the balance of the pattern can also be predicted well enough to yield returns in excess of the general market. Most academic studies of this approach have generally concluded that investing based on purely technical analysis does not work well.
The buy-and-hold-the-market approach is the benchmark against which any other approach to market investing should be measured. This strategy provides the returns that would be obtained by buying and holding the stock market, often defined as the Standard & Poor's 500. Of course, no individual investor would likely buy all 500 stocks that make up the index (although this can be achieved by buying shares in an S&P 500 index mutual fund). By investing in a large number of well-diversified stocks, however, an investor can build a portfolio which closely resembles the S&P 500.
The buy-and-hold-the-market investment approach is used as a benchmark because no other investment approach based on analysis is valid unless it can outperform the market over the long run. When an investment produces a return that's above the market return with the same risk, the difference between the two returns is referred to as an excess return. The excess return represents the added value of the approach that's used.
The type of strategy that you ultimately employ will depend in large measure on your conceptual views of two basic stock market theories. According to the efficient market theory, stock prices reflect all publicly available information concerning that stock and so are extremely close to the true value of the stock. This is not to say that prices reflect the stock's true value at all times, but that prices on average reflect the stock's true value. Variations about this average price can exist. Conversely, the random walk theory (named for the seemingly random steps of a drunken person) expounds that these variations are unpredictable; sometimes they are positive and sometimes negative. As such, they are unpredictable; they cannot be used to obtain excess returns.
Therefore, the investor who believes that the market is efficient would see no point in pursuing the fundamental approach which seeks to find stocks that are selling significantly above or below their value, because the price very closely reflects the stock's true value. Alternatively, this investor would concentrate on developing a more efficient portfolio rather than concentrating on specific stock selection, a portfolio that provides returns closest to the market's return at a specified level of market risk. The investor simply determines the amount of risk that he or she is willing to bear and then builds the portfolio accordingly.
Investors who believe that the market is inefficient proceed on the assumption that variations in the way people receive and evaluate information cause the prices of some stocks to deviate significantly from their true value. Therefore, they see occasions for finding under- and overpriced stocks through diligent analysis, and believe that they're able to outperform a buy-and-hold-the-market strategy.
Based on substantial research evidence, many analysts believe that the market often is inefficient, and that there are indeed opportunities for outperforming the market. The excess return potential generally appears to be in the range of 2 to 6 percent annually. Over a lifetime of investing, even relatively small additional returns such as this can lead to substantially greater wealth.