Investment Methods and Strategies
Various theories have been advanced to determine the best method of selecting securities. the theories differ primarily in the distinction drawn between speculative and investment strategies. These theories can be concisely described in the following terms:
Technical selection assumes that security prices usually move in identifiable patterns that can be determined through chart techniques to extrapolate trends. Fundamentalists rely heavily upon an analysis of discounted future cash flows to estimate the intrinsic worth of securities. Those who accept the efficient market theory hold that all important information associated with securities is already reflected in existing prices. Hence, analysis is not required.
A glossary of investment methods and strategies is shown here.
Glossary of Investment Methods and Strategies
Advance-decline: Breadth of market. If advances consistently outnumber declines, the market is considered to be in a bullish phase. When declines are more numerous than advances, the market is considered to be in a bearish phase. When the Dow Jones averages advance and the advance/decline ratio either does not advance or levels off, the advance is probably false. If the advance/decline ratio is strong but the Dow levels off, the Dow should begin to rise.
Averaging up: The technique of buying additional shares of a particular stock as the price of the stock rises to reduce the average cost of the stock.
Bear market: A down market; a stock market after it has developed a downward trend. A bear market will usually not last as long as a bull market; it declines more rapidly than a bull market goes up. When the Dow Jones industrial average fails to penetrate the peak of the preceding intermediate advance, a bear market is signalled. A bear market is confirmed when the next intermediate dip penetrates the low point of the preceding decline. The bear market will continue as long as these conditions exist. Chartists look for broad movement and increasing volume before they signal a primary trend. Can use effectively short selling, selling against the box, buying bonds, and options.
Blue chips: The common stock of well-established, profitable, and large U.S. companies, such as IBM, GE, GM, and many others.
Bond: Strategies include switching back and forth between stocks and bonds, depending upon market levels.
Breath-momentum index: A comparison of the amount of movement up or down of the advance-decline line with the movement of the New York Stock Exchange Index of stock prices. See advance-decline.
Breakouts: Sharp and strong upward or downward stock price movements from a previously horizontal pattern. Breakouts signal a significant move in the price of the stock. False breakouts are common.
Bull market: An up market; the market in an established upward movement. Bull markets typically last longer than do bear markets. Many signals are available to determine the end of a bull market, such as, low dividend yields on common stock and the floating of many new stock issues. When the Dow Jones industrial average fails to penetrate the low point of the preceding intermediate decline, a reversal of the bear (down) trend is possible. The bull market is confirmed when the next intermediate rise in the Dow penetrates the preceding peak. As long as these conditions keep recurring, the bull market continues.
Buy-and-hold: The strategy of buying common stock and holding it for an indefitine period. Investor ignores market fluctuations. Can be justified for selling the security if there are major changes in the corporation or in the security.
Cash flow per share: Net income plus expenses such as depreciation that do not involve actual cash outlays. Some analysts consider this ratio to be more significant than earnings per share; others maintain that it can be very misleading.
Cash position: Some investors hold large amounts of cash or Treasury Bills during a bear market or during the last stages of a bull market, anticipating more favorable opportunities in the future. During periods of declining market prices, investors hold a cash cushion to invest at a later date. A fully invested position, usually less than 3% cash, is a bearish signal; a strong cash position, over 10% is bullish. Companies having strong (weak) cash positions, can make (cannot make) substantial purchases and help the market rise.
Charts: Graphic presentation of stock prices and volume of trading frequently used to forecast the market. Examples of charting include simple-line charts, trend-line charts, moving-average charts, point-and-figure charts, and many others. Used frequently in technical analysis. See entry on Charting.
Climax: Sudden, sharp price trend changes on stock charts along with great increases in the volume of trading that signal immediate concern or opportunity.
Concept stocks: Stocks to which a big idea can be associated, such as a scientific breakthrough, a new drug discovery, and a new merchandising approach. Sharp price fluctuations are often associated with concept stocks.
Confidence index: Investor optimism and pessimism. A ratio of the yield on Barron's High-Grade Bond index to the yield on the Dow-Jones Composite Bond Average. Suggest the confidence of experienced investors in medium-grade corporate bonds relative to high-grade bonds. When lower-grade bond issues outperform high-grade bonds, the confidence index rises, which is an optimistic sign for stock prices. Investors are not worrying about safety and are willing to purchase a lower-quality bond. The converse is also true.
Consensus of indicators: An averaging by various statistical methods of many stock market price indicators (for example volume, short sales, free credit balance, advance-decline line at market tops and total short interest at market bottoms, and the odd-lot short sales ratio at market tops).
Constant-dollar plan: A plan that keeps a fixed number of dollars in stock with a fluctuating amount in bonds or other defensive instruments. If stocks rise, some shares are sold and the extra money beyond the previously decided fixed amount is used to buy bonds. If stocks go down, bonds are sold and the money is used to buy shares to bring the dollars in the stocks up to the desired amount.
Constant-ratio formula: A plan which keeps a fixed ratio of money in stock and bonds (for example, 50% in stocks and 50% in bonds). As the market fluctuates, stocks are sold and bonds bought, or vice versa, so as to keep the ratio constant. This plan is supposed to work well in a complete market cycle that includes some wide swings.
Contrary opinion: Action that differs from what the general investing public does at a certain time. Its purpose is to outsmart the market. The underlying idea of this theory is that what a majority of investors know is not worth knowing.
Convertible bonds: Convertibles may offer the stability of a bond in down markets and the capital gains opportunity of common stock in up markets. Provides some downside protection.
Divergence analysis: Analysis of the difference between the actions of sophisticated and unsophisticated investors (for example, short-sellers and specialists (sophisticated) versus odd-lot investors (unsophisticated)).
Diversification: Holding more than one stock of a security to reduce overall risk, especially to spread risk among various counterbalancing industries and among different corporations within each industry. Diversification can presumably be attained for an individual investor by holding between five to fifteen different securities. Diversification can also be achieved through investing in mutual funds.
Dollar averaging: Investing an equal amount of money at stated intervals (monthly, quarterly) in a particular security or group of securities. This practice should result in buying at low price levels to balance buying at higher prices. Dollar averaging is sometimes modified to allow increasing the amount of periodic investment when stock prices are low and decreasing the amount when stock prices are high.
Federal Reserve Board actions: Noting actions taken by the Board of Governors of the Federal Reserve System that can influence business and the stock market (for example, discount (interest) rates, margin requirements, and member bank's reserves (money supply)) to serve as an indicator of stock market behavior.
Gold stock price: Observe the prices of gold-mining companies stocks which tend to move in a direction opposite to that of the stock averages.
Government bonds: Purchase government bonds on margin when a business recession is due because the government will undoubtedly adopt easy money policies that will result in a drop in interest rates and an increase in bond prices. Government securities are usually purchased for the safety factor.
Graham formula: An investment timing plan that involves computing a normal or central value for earnings on the Dow-Jones Industrial Average and the yield on Moody's Corporate Aaa Bond Average. The formula involves a fundamental approach to investing.
Growth stocks: Stocks of companies with earnings above the average at an annual rate are assumed. Growth stocks tend to become overvalued and to move in comparatively wide swings.
Hedging: A sale or purchase of a contract for future delivery against a previous purchase or sale of an equal quantity of the same commodity or an equivalent quantity of another commodity that has a parallel price movement, and when it is expected that the transaction in the contract market will be cancelled by an offset transaction at the time the contemplated spot transaction is completed and before the futures contract matures; or, the practice of buying or selling futures to counterbalance an existing position in the trade market, thus avoiding the risk of unforseen major movements in price. Hedging may be accomplished in different ways in the stock market (for example, using options, to have a long position in stocks viewed favorably along with short positions in stocks viewed unfavorably; 50% long, 50% short; stable convertible bond and a common stock that fluctuates with the market in a bear market).
High-low index: A measure of the difference between the number of stocks making new highs in price for the year and those making new lows. Considered a good indicator of bull market tops; provides early warning signal for the market in general.
Income stocks: Stocks of companies that pay liberal and reliable dividends. However, the higher the yield, the higher the risk. Growth prospects should usually be considered.
Insider transactions: The buying and selling activities of directors, officers, and large stockholders, reported monthly in the Official Summary of Security Transactions and Holding (the Insider's Report, compiled by the SEC). Insider transactions can provide clues to stock prices.
Institutional investing: The investing activities of funds and other large investors of other people's money that dominate the stock market and sometimes provide clues concerning the volatility of stocks, diversification, risk, and other factors.
Investment advisory services: Advice about stock and bond markets, typically made available in newsletter form (for example, Value Line Investment Survey).
Investment clubs: Groups who agree to pool investment funds which meet regularly to determine jointly investment opportunities and decisions.
Leadership: Stocks leading the advance or decline in a market. The quality of the stocks providing market leadership is important. Following a long advance, if low-priced stocks are attracting the most value, the investor understands that the public is heavily invested. This could indicate a top. If the volume leaders are the blue-chip stocks, the advance has further to go.
Leverage: The advantage (or disadvantage) obtained by the use of borrowed money. In a rising market, the practice causes the asset value of the common stock to appreciate more rapidly percentage-wise than investing without the use of borrowed funds. Gains and losses are magnified through the se of leverage. Leverage in the stock market can be obtained through the use of margin, warrants, margined warrants, options, and convertibles.
Low-priced stocks: Stocks selling below a relative low amount (for example, $10), which are frequently noted for price volatility. One theory suggests buying such stocks toward the bottom of a typical yearly price range and selling toward the top of the range. When a preponderance of low-priced stocks among the leaders exists, the market is nearing the end of a rally. The beginning of an upswing reflects an investor preference for quality stock; after they have been bid up in price, the investor turns to the lower-quality issues. If the Dow Jones industrial average is rising and the average price of the leaders is high, the bull market should continue.
Margin Credit: A strategy that requires the investor to be willing to accept considerable losses. Margin requirements imposed by the SEC can also be used as an indicator of stock price movement.
Money supply: The expansion or contraction of the money supply has a relationship to stock prices, interest rates, and other factors affecting the market. Monetary indicators include net free bank reserves, member banks' borrowings, Treasury bill rates, the federal funds rate, the discount rate, interest rates, and others.
Monthly investment plan: An investment strategy that requires small investors to buy individual stocks in small dollar amounts on a periodic basis. Such plans are supposed to develop a habit of thrift in individuals.
Most active stocks: Stocks showing the largest volume of trading during a certain period (for example, daily, weekly, annually) can provide clues to market trends. For example, an increasing number of negative price movements in lists of most active stocks is often a signal of a bear market.
Moving average: An arithmetic mean that changes according to a specified period of time (for example, a three- or five-year moving average). Moving averages have been used to determine market trends and the rate of change of stock prices.
Municipal bonds: Debt issues of cities, states, and other local governments. Interest income is usually free of federal income tax and some state and local taxes. Municipals usually provide safety and a reasonable after-tax yield comparison with taxable securities, especially for taxpayers in a higher tax bracket.
Mutual funds: Companies that pool investment money from individuals and others that provide diversification and professional management.
New issues: Common stock issues of companies that are going public and are selling stock to the public for the first time. The term is also applied to new issues of corporate or municipal bonds. Studies indicate that the odds against new common stock issues are unfavorable.
New York Stock Exchange seat prices: The cost of membership on the exchange is considered by some investors to reflect optimistic or pessimistic expectations for the market in general.
Normal-value plans: Formula investment plans which rely on determining a normal stock market level that should exist at a particular time. The formula typically relates a stock market average to fundamental values, such as earnings, dividends, or interest rates.
Odd-lot short sales: Short sales in less than one hundred shares are sales by unsophisticated investors who are considered by some to be losers. A significant rise in the volume of odd-lot short selling is interpreted to mean that the stock market will improve, thus providing the odd-lot short seller a typical loss. The odd-lot short sales ratio is the ratio of odd-lot sales to regular odd-lot sales.
Options activity ratio: A speculative index based on the level of options activity compared with the volume of trading in the stock market.
Over-the-counter stocks: Unlisted stocks that sometimes offer the possibility of finding young and relatively small corporations that show promise.
Price-earnings ratio: A ratio of the market price of a stock to the stock's annual earnings per share. This ratio can indicate whether a particular stock is properly priced. A very high price/earnings ratio suggests high expectations for the future, which may be based merely on psychology. For some investors, the price/earnings ratio establishes a relationship between the intrinsic value, or justified price, of a stock and its current market price.
Intrinsic value = Earnings per share x P/E RATIO
The P/E ratios are inversely related to interest rates because interest rates are directly related to rates of return.
Psychology: The emotional and behavioral patterns of investors and speculators is a factor in determining stock prices and trends.
Scale trading: An investment strategy involving buying a specified number of shares of a particular stock whenever the price of the stock moves downward by a certain amount (for example, a half pint), and selling the same number of shares each time the price of the stock rises by a greater amount (for example, a full point).
Seasonal variations: Stock prices fluctuate according to the hour, the day, the month, the season, the year, a series of years, and other periods. Experts often expect short-term price changes for stocks to be random movements. Cyclical movements involve longer times and reflect stock movements through periods of recession, depression, recovery, and inflation. Industries that tend to resist recession include health and food.
Selling strategy: An investment plan established to suggest a point when a security should be sold. Many investors suggest that one should sell a stock if he or she would not want to buy more of the stock. Many share signals have been proposed (for example, a decline in the price-earnings ratio of a stock).
Short interest: The number of shares that have been sold short of a particular stock or of the market as a whole. The sort interest ratio is the ratio of total short interest on the New York Stock Exchange to daily average stock volume. A ratio of more than approximately 2.00 is considered bullish; a ratio of less than 2.00 is considered bearish. This ratio is commonly considered to be a contrary opinion indictor (short sellers are usually wrong). A falling short interest is considered to be bullish. The greater the number of shares sold short, the stronger the technical position. Speculators must back the securities they sold. A market with a large short position is in a strong position to rally rapidly if the market remains strong. Short sellers become anxious during a rally and cover their short positions.
Short selling: A strategy that generally goes against the market. Short selling is generally considered to be speculative and risky. Folklore says that one should never stay short after the short interest becomes very large. Relatively active short selling by members of the New York Stock Exchange tends to reflect sophisticated selling and indicates a possible negative stock market.
Special situations: Conditions that promise large capital gains with limited risk accompanied by an uncertain time factor. Special situations include mergers and reorganizations, large liquid assets, liquidations, stocks with high volatility, litigations, changes in law, management changes, technological innovations, marketing innovations, turnaround situations, and many more.
Speculation index: A ratio of lower quality stocks to activity in higher-quality stocks. a high level of volume on the American Stock Exchange (considered speculative) compared with the volume on the New York Stock Exchange could indicate considerable speculative interest in the market.
Stock-Bond yield spread: The difference between the average dividend yield on common stocks and the average yield from interest on high grade corporate bonds. A stock yield of 10% and a bond yield of 8% would be considered a negative spread and could indicate that stocks are overvalued.
Stop-loss orders: An order left with a broker to sell a stock if it drops to a certain price in order to stop the loss.
Support and resistance levels: A support level is a price level that a stock or the market has difficulty in breaking through on the downside; a resistance level is the same on the upside. Buying activity increases support levels; selling pressures increase resistance levels. Levels of support and resistance can indicate a major change in the market.
Tape trading: Reading the stock market tape is a very short-term method of forecasting stock movements, often used by professional traders. Through a careful examination of the tape as transactions occur, the astute tape reader hopes to anticipate price changes and to take advantage of such changes when they occur.
Tax investing: Investing strategy in which the tax consequences are the major considerations.
Trends: Strategies based on the tendency of stock prices to follow established trends or directions (for example, bull or bear markets). Matters to consider are how steep is the trend, has the trend been tested, and similar questions.
Undervalued and overvalued securities: Stocks or bonds that are priced below or above what is a reasonable or normal value as related to underlying net assets, earning power, or other securities may offer opportunities for profitable investment. Searching for undervalued securities is a form of bargain hunting.
Upside-downside volume: A comparison of the trading volume of stocks with rising prices with those of stocks with falling prices can provide clues of the market direction.
Volume of trading: The number of shares of stock traded during a particular period of time can provide a basis for trading or not trading. The volume of trading typically slows before the top of a bull market and before the bottom of a bear market.
Warrants: Warrants giving the holder the right to buy a specified amount of a particular common stock at a certain price within a specified period of time can be attractive securities where leverage is a factor.
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