A Course Material On Security Analysis and Portfolio Management
A Course Material On Security Analysis and Portfolio Management
A Course Material On Security Analysis and Portfolio Management
A Course Material on
SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
By
ASSISTANT PROFESSOR
DEPARTMENT OF COMMERCE
VARANASI(U.P ) 221002
DEPARTMENT OF COMMERCE
Code: MC 401 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
In the above discussion, we concentrated on the word „Investment‟. But for making investment,
we need to make security analysis. It then becomes necessary to define properly investment and
security analysis at the outset.
Investments: meaning, types and characteristics Financial markets have the basic function of
mobilising the investments needed by corporate entities. They also act as marketplaces for
investors who are attracted by the returns offered by the investment opportunities in the market.
In this context there is a need to understand the meaning of investment and the motives of
investment.
Investment may be defined as an activity that commits funds in any financial/physical form in
the present with an expectation of receiving additional return in the future. The expectation
brings with it a probability that the quantum of return may vary from a minimum to a maximum.
This possibility of variation in the actual return is known as investment risk. Thus every
investment involves a return and risk.
Investment is an activity that is undertaken by those who have savings. Savings can be defined
as the excess of income over expenditure. However, all savers need not be investors. For
example, an individual who sets aside some money in a box for a birthday present is a saver, but
cannot be considered an investor. On the other hand, an individual who opens a savings bank
account and deposits some money regularly for a birthday present would be called an investor.
The motive of savings does not make a saver an investor. However, expectations distinguish the
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Code: MC 401 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
investor from a saver. The saver who puts aside money in a box does not expect excess returns
from the savings. However, the saver who opens a savings bank account expects a return from 3
the bank and hence is differentiated as an investor. The expectation of return is hence an
essential characteristic of investment.
An investor earns/expects to earn additional monetary value from the mode of investment that
could be in the form of physical/financial assets. A bank deposit is a financial asset. The
purchase of gold would be a physical asset. Investment activity is recognised when an asset is
purchased with an intention to earn an expected fund flow or an appreciation in value.
An individual may have purchased a house with an expectation of price appreciation and may
consider it as an investment. However, investment need not necessarily represent purchase of a
physical asset. If a bank has advanced some money to a customer, the loan can be considered as
an investment for the bank. The loan instrument is expected to give back the money along with
interest at a future date. The purchase of an insurance plan for its benefits such as protection
against risk, tax benefits, and so on, indicates an expectation in the future and hence may be
considered as an investment.
From the above examples it can be seen that investment involves employment of funds with the
aim of achieving additional income or growth in value. The essential quality of an investment is
that it involves the expectation of a reward. Investment, hence, involves the commitment of
resources at present that have been saved in the hope that some benefits will accrue from them in
the future.
Types of investments
Investments may be classified as financial investments or economic investments. In the financial
sense, investment is the commitment of funds to derive future income in the form of interest,
dividend, premium, pension benefits, or appreciation in the value of the initial investment.
Hence, the purchase of shares, debentures, post office savings certificates, and insurance policies
are all financial investments. Such investments generate financial assets. These activities are
undertaken by anyone who desires a return and is willing to accept the risk from the financial
instrument.
Economic investments are undertaken with an expectation of increasing the current economy‟s
capital stock that consists of goods and services. Capital stock is used in the production of other
goods and services desired by the society. Investment in this sense implies the expectation of
formation of new and productive capital in the form of new constructions, plant and machinery,
inventories, and so on. Such investments generate physical assets and also industrial activity.
These activities are undertaken by corporate entities that participate in the capital market.
Financial investments and economic investments are, however, related and dependent. The
money invested in financial investments is ultimately converted into physical assets. Thus, all
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Code: MC 401 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
investments result in the acquisition of some asset, either financial or physical. In this sense,
markets are also closely related to each other. Hence, the perfect financial market should reflect 4
the progress pattern of the real market since, in reality, financial markets exist only as a support
to the real market.
Characteristics of investment
The features of economic and financial investments can be summarised as return, risk, safety,
and liquidity.
Return: All investments are characterised by the expectation of a return. In fact, investments are
made with the primary objective of deriving a return. The expectation of a return may be from
income (yield) as well as through capital appreciation. Capital appreciation is the difference
between the sale price and the purchase price of the investment. The dividend or interest from
the investment is the yield. Different types of investments promise different rates of return. The
expectation of return from an investment depends upon the nature of investment, maturity
period, market demand, and so on.
The purpose for which the investment is put to use influences, to a large extent, the expectation
of return of the investors. Investment in high growth potential sectors would certainly increase
such expectations.
The longer the maturity period, the longer is the duration for which the investor parts with the
value of the investment. Hence, the investor would expect a higher return from such investments.
Risk: Risk is inherent in any investment. Risk may relate to loss of capital, delay in repayment
of capital, non-payment of interest, or variability of returns. While some investments such as
government securities and bank deposits are almost without risk, others are more risky. The risk
of an investment is determined by the investment‟s maturity period repayment capacity, nature of
return commitment, and so on.
The longer the maturity period, greater is the risk. When the expected time in which the
investment has to be returned is a long duration, say 10 years, instead of five years, the
uncertainty surrounding the return flow from the investment increases. This uncertainty leads to
a higher risk level for the investment with longer maturity rather than on an investment with
shorter maturity.
Safety: The safety of investment is identified with the certainty of return of capital without loss
of money or time. Safety is another feature that an investor desires from investments. Every
investor expects to get back the initial capital on maturity without loss and without delay.
Investment safety is gauged through the reputation established by the borrower of funds. A
highly reputed and successful corporate entity assures the investors of their initial capital. For
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Code: MC 401 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
example, investment is considered safe especially when it is made in securities issued by the
government of a developed nation. 5
Liquidity: An investment that is easily saleable or marketable without loss of money and
without loss of time is said to possess the characteristic of liquidity. Some investments such as
deposits in unknown corporate entities, bank deposits, post office deposits, national savings
certificate, and so on are not marketable. There is no well-established trading mechanism that
helps the investors of these instruments to subsequently buy/sell them frequently from a market.
Investment instruments such as preference shares and debentures (listed on a stock exchange) are
marketable. The extent of trading, however, depends on the demand and supply of such
instruments in the market for the investors. Equity shares of companies listed on recognised
stock exchanges are easily marketable. A well-developed secondary market for securities
increases the liquidity of the instruments traded therein.
Types of investors
Investors can be classified on the basis of their risk bearing capacity. Investors in the financial
market have different attitudes towards risk and hence varying levels of risk-bearing capacity.
Some investors are risk averse, while some may have an affinity for risk. The risk bearing
capacity of an investor is a function of personal, economic, environmental, and situational factors
such as income, family size, expenditure pattern, and age. A person with a higher income is
assumed to have a higher risk-bearing capacity. Thus investor can be classified as risk seekers,
risk avoiders, or risk bearers. A risk seeker is capable of assuming a higher risk while a risk
avoider choose instruments that do not show much variation in returns. Risk bearers fall in
between these two categories. They assume moderate levels of risk.
Investors can also be classified on the basis of groups as individuals or institutions. Individual
investors operate alongside institutional investors in the investment market. However, their
characteristics are different. Individual investors in any financial market are large in number, but
in terms of value of investment they are comparatively smaller. Institutional investors, on the
other hand, are organisations with surplus funds beyond immediate business needs or
organisation whose business objective is investment. Mutual funds, investment companies,
banking and non-banking companies, insurance corporations, and so on are organisations with
large surplus funds to be invested in various profitable avenues. While these institutional
investors are fewer in number compared to individual investors, their resources are much larger.
Institutional investors engage professional fund managers to carry out extensive analysis.
Institutional investors and individual investors combine to make the investment market dynamic.
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Code: MC 401 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
Investment and speculation both involve the purchase of assets such as shares and securities,
with an expectation of return. However, investment can be distinguished from speculation by 6
risk bearing capacity, return expectations, and duration of trade.
The capacity to bear risk distinguishes an investor from a speculator. An investor prefers low risk
investments, whereas a speculator is prepared to take higher risks for higher returns. Speculation
focuses more on returns than safety, thereby encouraging frequent trading without any intention
of owning the investment.
The speculator‟s motive is to achieve profits through price change, that is, capital gains are more
important than the direct income from an investment. Thus, speculation is associated with buying
low and selling high with the hope of making large capital gains. Investors are careful while
selecting securities for trading. Investments, in most instances, expect an income in addition to
the capital gains that may accrue when the securities are traded in the market.
Investment is long term in nature. An investor commits funds for a longer period in the
expectation of holding period gains. However, a speculator trades frequently; hence, the holding
period of securities is very short.
The identification of these distinctions helps to define the role of the investor and the speculator
in the market. The investor can be said to be interested in a good rate of return on a consistent
basis over a relatively longer duration. For this purpose the investor computes the real worth of
the security before investing in it. The speculator seeks very large returns from the market
quickly. For a speculator, market expectations and price movements are the main factors
influencing a buy or sell decision. Speculation, thus, is more risky than investment.
In any stock exchange, there are two main categories of speculators called the bulls and bears. A
bull buys shares in the expectation of selling them at a higher price. When there is a bullish
tendency in the market, share prices tend to go up since the demand for the shares is high. A bear
sells shares in the expectation of a fall in price with the intention of buying the shares at a lower
price at a future date. These bearish tendencies result in a fall in the price of shares.
A share market needs both investment and speculative activities. Speculative activity adds to the
market liquidity. A wider distribution of shareholders makes it necessary for a market to exist.
Investment Vs Gambling
Investment can also to be distinguished from gambling. Examples of gambling are horse race,
card games, lotteries, and so on. Gambling involves high risk not only for high returns but also
for the associated excitement. Gambling is unplanned and unscientific, without the knowledge of
the nature of the risk involved. It is surrounded by uncertainty and a gambling decision is taken
on unfounded market tips and rumours. In gambling, artificial and unnecessary risks are created
for increasing the returns. Investment is an attempt to carefully plan, evaluate, and allocate funds
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Code: MC 401 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
to various investment outlets that offer safety of principal and expected returns over a long
period of time. Hence, gambling is quite the opposite of investment even though the stock 7
market has been euphemistically referred to as a “gambling den”.
Investment in capital market is made in various financial instruments, which are all claims on
money. These instruments may be of various categories with different characteristics. These are
all called securities in the market parlance. In a legal sense also, the Securities Contracts
Regulation Act, (1956) has defined the security as inclusive of shares, scrips, stocks, bonds,
debentures or any other marketable securities of a like nature or of any debentures of a company
or body corporate, the Government and semi-Government body etc. It includes all rights and
interests in them including warrants, and loyalty coupons etc., issued by any of the bodies,
organisations or the Government. The derivatives of securities and Security Index are also
included as securities in the above definition in 1998.
In the strict sense of the word, a security is an instrument of promissory note or a method of
borrowing or lending or a source of contributing to the funds needed by a corporate body or non-
corporate body. Private security for example is also a security as it is a promissory note of an
individual or firm and gives rise to a claim on money. But such private securities or even
securities of private companies or promissory notes of individuals, partnerships or firms to the
extent that their marketability is poor or nil, are not part of the capital market and do not
constitute part of the security analysis. In nutshell, securities are financial instruments that have
been created to represent a legal obligation to pay a sum in future in return for the current receipt
of value. Securities thus represent the cash equivalent received from another person.
Definition of security analysis: For making proper investment involving both risk and return,
the investor has to make a study of the alternative avenues of investment– their risk and return
characteristics and make proper projection or expectation of the risk and return of the alternative
investments under consideration. He has to tune the expectations to his preferences of the risk
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Code: MC 401 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
and return for making a proper investment choice. The process of analysing the individual
securities and the market as a whole and estimating the risk and return expected from each of the 8
investments with a view to identifying undervalued securities for buying and overvalued
securities for selling is both an art and a science and this is what is called security analysis.
Security Analysis in both traditional sense and modern sense involves the projection of future
dividend, or earnings flows, forecast of the share price in the future and estimating the intrinsic
value of a security based on the forecast of earnings or dividends. Thus, security analysis in
traditional sense is essentially an analysis of the fundamental value of a share and its forecast for
the future through the calculation of its intrinsic worth of the share.
Modern security analysis relies on the fundamental analysis of the security, leading to its
intrinsic worth and also risk-return analysis depending on the variability of the returns,
covariance, safety of funds and the projections of the future returns. If the security analysis is
based on fundamental factors of the company, then the forecast of the share price has to take into
account inevitably the trends and the scenario in the economy, in the industry to which the
company belongs and finally the strengths and weaknesses of the company itself- its
management, promoters‟ track record, financial results, projections of expansion, diversification,
tax planning etc. all these studies are only a part of the total security analysis that the investor
should aim at.
As referred earlier, portfolios are combinations of assets held by the investors. These
combinations may be of various asset classes like equity and debt and of different issuers like
Government bonds and corporate debt or of various instruments like discount bonds, warrants,
debentures and Blue chip equity or scrip of emerging blue chip companies.
The traditional Portfolio Theory aims at the selection of such securities that would fit in well
with the asset preferences, needs and choices of the investor. Thus, a retired executive invests in
fixed income securities for a regular and fixed return. A business executive or a young
aggressive investor on the other hand invests in new and growing companies and in risky
ventures. Modern Portfolio Theory postulates that maximisation of return and or minimisation of
risk will yield optimal returns and the choice and attitudes of investors are only a starting point
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Code: MC 401 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
for investment decision and that rigorous risk return analysis is necessary for optimisation of
returns. 9
In risk return analysis, the attitudes and preferences of investors are taken into account as also
their risk-return trade off stemming from the analysis of individual securities. The return on
portfolio is a weighted average of returns of the individual stocks; and the weights are
proportional to each stock‟s percentage in the total portfolio. Besides the stocks when put
together in a basket may not give a total risk which is the mathematical equivalent of total of
risks of all the individual stocks, due to the simple reason that the risks of some stocks may be
compensated by the risks of other stocks or vice versa. The risks of some stocks can also be
accentuated by those of others in the portfolio. The modern portfolio theory states that the
combined risk of a portfolio may be greater or lesser than the sum of the risks of the components
of individual securities.
Primary market
The primary market is the doorway for corporate enterprises to enter the capital market. The
issues of new securities are offered to the public through the primary market. The issue is thus an
open public offer to sell the securities. The sale is made at a value predetermined by the firm
issuing the security. Sometimes a road show is conducted to feel the pulse of the public in fixing
the value for a security. The securities have a face value, which is the denomination in which it is
divided. For instance, an instrument could have a face value of Re 1, Rs. 5, Rs. 10, or Rs. 100 in
India. This denomination determines the number of units of the security that are offered to the
public. The price at which the security is offered to the public is the offer price of the instrument.
This price could be equal to or greater or lesser than the face value. When the offer price is
greater than the face value, the offer is said to be at a premium. When the offer price is less than
the face value, the offer is at a discount. When the two prices are equal, the offer is at par.
Several intermediaries have sprung up to help corporate entities to offer their debt and equity
instruments to the public. Merchant bankers and underwriters are the major intermediaries who
help to match the fund requirement of corporate entities with the surplus fund position of public.
The public is represented by both individual investors and institutional investors. Sometimes,
when the market is dominated by institutions, the market is said to be institutionalised. Once the
offer process of the securities to the public is complete, the securities are listed in the markets.
The corporate then has to comply with the specific regulations of each local market in which its
securities are listed.
Secondary market
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Code: MC 401 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
The secondary market refers to the exchange of securities that have been listed through the
primary market. The price at which it is traded in the capital market is the market price of the 10
instrument. It is the secondary market that offers tradability to the financial instruments. The
number of financial instruments participating in the secondary market hence, cannot exceed the
number of financial instruments recorded through the primary market. The secondary market
also comes under the regulatory authorities of the market and the main role of the regulator in the
secondary market is to safeguard the interest of players in the market. Both individuals and
institutions can take part in the secondary market. Brokers and depositories are the main
intermediaries in this market, who transact business on behalf of the investors. The brokers can
appoint a network of subbrokers to mobilise investors participation in the market. Depositories
help in scripless trading by holding investor accounts in electronic media.
Over a period of time, the secondary market has grown in size and in terms of efficiency. The
secondary market may be further sub-divided into the spot market and derivative market.
2. The new issue market provides a direct link between the prospective investors and the
company. By providing liquidity and safety, the stock markets encourage the public to subscribe
to the new issues. The marketability and the capital appreciation provided in the stock market are
the major factors that attract the investing public towards the stock market. Thus, it provides an
indirect link between the savers and the company.
3. The stock exchanges through their listing requirements, exercise control over the primary
market. The company seeking for listing on the respective stock exchange has to comply with all
the rules and regulations given by the stock exchange.
4. Though the primary and secondary markets are complementary to each other, their functions
and the organisational set up are different from each other. The health of the primary market
depends on the secondary market and vice versa.
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4. All companies participate into primary 4. Securities of only listed companies can be
market. traded at Stock exchanges. 11
5. No tangible form or administrative set-up. 5. Has a definite administrative set-up and a
Recognised only by the services it renders. tangible form.
FUNDAMENTAL ANALYSIS
FUNDAMENTAL ANALYSIS:
Fundamental analysis is used to determine the intrinsic value of the share by examining the
underlying forces that affect the well being of the economy, Industry groups and companies.
Fundamental analysis is to first analyze the economy, then the Industry and finally individual
companies. This is called as top down approach.
The actual value of a security, as opposed to its market price or book value is called
intrinsic value. The intrinsic value includes other variables such as brand name,
trademarks, and copyrights that are often difficult to calculate and sometimes not
accurately reflected in the market price. One way to look at it is that the market
capitalization is the price (i.e. what investors are willing to pay for the company and
intrinsic value is the value (i.e. what the company is really worth).
At the economy level, fundamental analysis focus on economic data (such as GDP,
Foreign exchange and Inflation etc.) to assess the present and future growth of the
economy.
At the industry level, fundamental analysis examines the supply and demand forces for
the products offered.
At the company level, fundamental analysis examines the financial data (such as balance
sheet, income statement and cash flow statement etc.), management, business concept
and competition.
ECONOMIC ANALYSIS:
Economic analysis occupies the first place in the financial analysis top down approach. When the
economy is having sustainable growth, then the industry group (Sectors) and companies will get
benefit and grow faster. The analysis of macroeconomic environment is essential to understand
the behavior of the stock prices. The commonly analysed macro economic factors are as follows.
Gross domestic product (GDP): GDP indicates the rate of growth of the economy. GDP
represents the value of all the goods and services produced by a country in one year. The higher
the growth rate is more favourable to the share market.
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Code: MC 401 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
Savings and investment: The economic growth results in substantial amount of domestic
savings. Stock market is a channel through which the savings of the investors are made available 12
to the industries. The savings and investment pattern of the public affect stock market.
Inflation: Along with the growth of GDP, if the inflation rate also increases, then the real rate of
growth would be very little. The decreasing inflation is good for corporate sector.
Interest rates:
The interest rate affects the cost of financing to the firms. A decrease in interest rate implies
lower cost of finance for firms and more profitability.
Budget:
Budget is the annual financial statement of the government, which deals with expected revenues
and expenditures. A deficit budget may lead to high rate of inflation and adversely affect the cost
of production. Surplus budget may result in deflation. Hence, balanced budget is highly
favourable to the stock market.
The tax structure: The tax structure which provides incentives for savings and investments.
The balance of payment: The balance of payment is the systematic record of all money transfer
between India and the rest of the world. The difference between receipts and payments may be
surplus or deficit. If the deficit increases, the rupee may depreciate against other currencies. This
would affect the industries, which are dealing with foreign exchange.
Demographic factors: The demographic data provides details about the population by age,
occupation, literacy and geographic location. This is needed to forecast the demand for the
consumer goods.
Political stability: A stable political system would also be necessary for a good performance of
the economy. Political uncertainties and adverse change in government policy affect the
industrial growth.
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Code: MC 401 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
When the demand for industrial products is seasonal, their problems may spoil the growth
prospects. If it is consumer product, the scale of production and width of the market will
determine the selling and advertisement cost. The nature of industry is also an important factor
for determining the scale of operation and profitability.
Demand and market: If the industry is to have good prospects of profitability, the demand for
the product should not be controlled by the government.
Government policy: The government policy is announced in the Industrial policy resolution and
subsequent announcements by the government from time to time. The government policy with
regard to granting of clearances, installed capacity, price, distribution of the product and
reservation of the products for small industry etc are also factors to be considered for industrial
analysis.
Labour and other industrial problems: The industry has to use labour of different categories
and expertise. The productivity of labour as much as the capital efficiency would determine the
progress of the industry. If there is a labour problem that industry should be neglected by the
investor. Similarly when the industries have the problems of marketing, investors have to be
careful when investing in such companies.
Management: In case of new industries, investors have to carefully assess the project reports
and the assessment of financial institutions in this regard. The capabilities of management will
depend upon tax planning, innovation of technology, modernisation etc. A good management
will also insure that their shares are well distributed and liquidity of shares is assured.
Future prospects: It is essential to have an overall picture of the industry and to study their
problems and prospects. After a study of the past, the future prospects of the industry are to be
assessed. When the economy expands, the performance of the industries will be better. Similarly
when the economy contracts reverse will happen in the Industry. Each Industry is different from
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Code: MC 401 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
the other. Cement Industry is entirely different from Software Industry or Textile Industry in its
products and process. 14
Company analysis is a study of variables that influence the future of a firm both qualitatively and
quantitatively. It is a method of assessing the competitive position of a firm, its earning and
profitability, the efficiency with which it operates its financial position and its future with respect
to earning of its shareholders.
The fundamental nature of the analysis is that each share of a company has an intrinsic value
which is dependent on the company's financial performance. If the market value of a share is
lower than intrinsic value as evaluated by fundamental analysis, then the share is supposed to be
undervalued. The basic approach is analysed through the financial statements of an organisation.
The company or corporate analysis is to be carried out to get answer for the following two
questions.
How has the company performed in comparison with the similar company in the same
Industry?
How has the company performed in comparison to the early years?
Before making investment decision, the business plan of the company, management, annual
report, financial statements, cash flow and ratios are to be examined for better returns.
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15
TECHNICAL ANALYSIS:
Technical analysis involves a study of market generated data like prices and volumes to
determine the future direction of price movement. Martin J.Pring explains as The technical
approach to investing is essentially a reflection of the idea that prices move in trends which
are determined by the changing attitudes of investors toward a variety of economic,
monetary, political and psychological forces. The art of technical analysis-for it is an art-is to
identify trend changes at an early stage and to maintain an investment posture until the
weight of the evidence indicates that the trend has been reversed.
Basic assumption
1. The market and / or an individual stock act like a barometer rather than a thermometer.
Events are usually discounted in advance with movements as the likely result of informed
buyers and sellers at work.
3. The third assumption is an observation that deals with the scope and extends of market
movements in relation to each other.
The key differences between technical analysis and fundamental analysis are as follows:
1. Technical analysis mainly seeks to predict short term price movements, whereas
fundamental analysis tries to establish long term values.
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Code: MC 401 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
2. The focus of technical analysis is mainly on internal market data, particularly price and
volume data. The focus of fundamental analysis is on fundamental factors relating to the 16
economy, the industry, and the firm.
Technical analysts, while defining their own theory about stock price behavior and
criticizing the fundamental school, do feel that there is some merit in the fundamental
analysis also. But according to them, the method is very tedious and it takes a rather long
time for the common man to evaluate stocks through this method. They consider their own
techniques and charts as superior to fundamental analysis. Some of their theories, techniques
and methods of stock prices are given below:
The basic concepts underlying chart analysis are: (a) persistence of trends; (b) relationship
between volume and trend; and (c) resistance and support levels.
Trends: The key belief of the chartists is that stock prices tend to move in fairly persistent
trends. Stock price behavior is characterized by inertia: the price movement continues along
a certain path (up, down or sideways) until it meets an opposing force, arising out of an
altered supply-demand relationship.
Relationship between volume and trends: Chartists believe that generally volume and trend
go hand in hand. When a major upturn begins the volume of trading increases as the price
advances and decreases as the price declines. In a major down turn, the opposite happens;
the volume of trading increases as the price declines and decreases as the price rallies.
Support and Resistance levels: Chartists assume that it is difficult for the price of a share to
rise above a certain level called the resistance level and fall below a certain level called a
support level. Why? The explanation for the first claim goes as follows. If investors find that
prices fall after their purchases, they continue to hang on to their shares in the hope of a
recovery. And when the price rebounds to the level of their purchase price, they tend to sell
and heave sigh of relief as they break even.
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17
A corollary is that investors will also be less likely to discover great bargains and thereby
earn extraordinary high rates of return. The requirements for a securities market to be
efficient market are;
(1) Prices must be efficient so that new inventions and better products will cause a firm s
securities
prices to rise and motivate investors to supply capital to the firm (i.e., buy its stock);
(2) Information must be discussed freely and quickly across the nations so all investors can
react to
new information;
(5) Every investor is allowed to borrow or lend at the same rate; and, finally
(6) Investors must be rational and able to recognize efficient assets and that they will want to
invest money where it is needed most (i.e., in the assets with relatively high returns).
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2) Semi-strong form efficiency - Prices reflect not only all information found in the record of
past prices 18
and volumes but also all other publicly available information;
3) Strongform efficiency - Prices reflect all available information, public as well as private.
Serial Correlation Test: Serial Correlation is said to measure the association of a series of
numbers which are separated by some constant time period. One way to test for randomness in
stock price changes is to look at their serial correlations. Is the price change in one period
correlated with the price change in some other period? If such auto-correlations are negligible,
the price changes are considered to be serially independent. Numerous serial correlation studies,
employing different stocks, different time-lags, and different time-periods, have been conducted
to detect serial correlations.
Run Test: Ren Test was also made by Fama to find out it price changes were likely to be
followed by further price changes of the same sign. Run Test ignored the absolute values of
numbers in the series and took into the research only the positive and negative signs. Given a
series of stock price changes, each price (+) id it represents an increase or a minus (-) if it
represents a decrease. A run occurs when there is not difference between the sign of two
changes. When the sign of change differs, the run ends and a new run begin. To test a series of
price changes for independence, the number of runs in that series is compared to see whether it is
statistically different from the number of runs in a purely random series of the same size. Many
studies have been carried out, employing the runs test of independence. They did not detect any
significant relationship between the returns of security in one period and the returns in prior
periods and made a conclusion that the security prices followed a random walk.
Filter Rules Test: The use of charts is essentially a technique for filtering out the important
information from the unimportant. Alexander and Fama and Blume took the idea that price and
volume data are supposed to tell the entire story we need to know to identify the important action
in stock prices. They applied filter rules to see how well price changes pick up both trends and
reverses which chartists claim their charts do. If a stock moves up X per cent, buy it and hold it
long; if it then reverses itself by the same percentage, sell it and take a short position in it.
DEPARTMENT OF COMMERCE
Code: MC 401 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
Portfolio study: In a portfolio study, a portfolio of stocks having the observable characteristic
(low price earnings ratio or whatever) is created and tracked over time see whether it earns
superior risk-adjusted returns. Steps involved in a portfolio study are as follows:
Define the variable (characteristic) on which firms will be classified. The proposed
investment strategy spells out the relevant variable. The variable must be observable, but
not necessarily numerical.
DEPARTMENT OF COMMERCE
Code: MC 401 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
Classify firms into portfolios based upon the magnitude of the variable. Collect data on
the variable for every firm in the defined universe at the beginning of the period and use 20
that information for classifying firms into different portfolios.
Compute the returns for each portfolio on the returns for each firm in each portfolio for
the testing period and calculate the return for each portfolio, assuming that the stocks
included in the portfolio are equally weighted.
Calculate the excess returns for each portfolio. The calculation of excess returns earned
by a portfolio calls for estimating the portfolio beta and determining the excess returns
Assess whether the average excess returns are different across the portfolios. Several
statistical tests are available to test whether the average excess returns differ across these
portfolios. Some of these tests are parametric and some nonparametric. Many portfolio
studies suggest that it is not possible to earn superior riskadjusted returns by trading on
some observable characteristics. However, several portfolio studies have documented
inefficiencies and anomalies.
Strong-Form of EMH
The strong-form efficient market hypothesis holds that all available information, public or
private, is reflected in the stock prices. The strong form is concerned with whether or not certain
individuals or groups of individuals possess inside information which can be used to make above
average profits. If the strong form of the efficient capital market hypothesis holds, then and day
is as good as any other day to buy any stock. This the most extreme form of the efficient market
hypothesis. Most of the research work has indicated that the efficient market hypothesis in the
strongest form does not hold good.
DEPARTMENT OF COMMERCE
Code: MC 401 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
Financial Market Overreaction: One of the most intriguing issues to emerge in the past
few years is the notion of market overreaction to new information (both positive and
negative). Many practitioners have insisted for years that markets to overreact. Recent
statistical evidence for both the market as a whole and individual security has shown errors in
security prices that are systematic and therefore predictable. Overreactions are sometimes
called reversals. Stocks that perform poorly in period suddenly reverse direction and start
performing well in a subsequent period, and vice versa. Several studies have found that stock
returns over longer time horizons (in excess of one year) display significant negative serial
correlation.
Calendar-Based Anomalies: Are there better times to own stocks than others? Should you
avoid stocks on certain days? The evidence seems to suggest that several calendar-based
anomalies exist. The two best known, and widely documented, are the weekend effect and
the January effect.
Weekend Effect: Studies of daily returns began with the goal of testing whether the markets
operate on calendar time or trading time. In other words, are returns for Mondays (i.e.,
returns over Friday-to-Monday periods) different from the other day of the week returns?
The answer to the question turned out to be yes, the trend was called the weekend effect.
Monday returns were substantially lower than other daily returns. One study found that
Mondays produced a mean return of almost-35 percent. By contrast, the mean annualized
returns on Wednesdays was more than +25 per cent.
The January Effect: Stock returns appear to exhibit seasonal return patterns as well. In
other words, returns are systematically higher in some months than in others. Initial studies
found that returns were higher in January for all stocks (thus this anomaly was dubbed the
January effect) whereas later studies found the January effect was more pronounced for small
stocks than for large ones. One widely accepted explanation for the January effect is tax-loss
selling by the investors at the end of December. Because this selling pressure depresses
prices at the end of the year, it would be reasonable to expect a bounce-back in prices during
January. Small stocks, the argument goes, are more susceptible to the January effect because
DEPARTMENT OF COMMERCE
Code: MC 401 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
their prices are more volatile, and institutional investors (many of whom are tax-exempt) are
less likely to invest in shares of small companies 22
DEPARTMENT OF COMMERCE