March 28, 2009

Fundamental v/s Technical Analysis

The other day i was wondering about the investment strategy followed by well-known and highly successful investors. Take the case of Warren Buffet. The 80 something man has made billions through "correct" investing. There are mainly 2 ways of investment strategy "Fundamental Analysis" and "Technical Analysis" and i believe most of the successful investors (including Buffet) find favor with Technical Analysis even though they keep a close eye on Fundamental values.

Successful Technicians are the people who believe in market inefficiency. They believe they can get an edge by acquiring critical information much ahead of others and they really do ! They also use a Contrarian approach to their Investments. Time and again Buffet has mentioned about doing the exact opposite of what the majority of investors are thinking/doing. i.e. taking a view contrary to that of the market. In other words Buy when others are Selling and Sell when others are Buying. Be Bullish when Market is Bearish and vice-versa. But most of the investors find adopting this strategy extremely tough. The reason? FEAR. But they have no problem in following the herd mentality. The reason? GREED.

On what basis can one decide on the general market view? Well, there are various factors (signals) that can aid in understanding the view of the Market and then taking a contrary approach to the market (either buy or sell decisions). Some of these ratios are available to the general public free of cost. Some of these signals are

1. Mutual Funds Cash Ratio (Liquidity Ratio) : varies from 4% to 14%. higher cash ratio means market view is bearish.
2. Analysts recommendation of sectors/stocks : the most recommended ones (80% or more votes) would tend to be overbought and thereby adjust downwards in future.
3. Yield Spreads of bonds - higher values indicate higher risk taking appitite and thereby bullish market view.
4. Maring balances in demat accounts - Increase in balance indicate market is bullish.
5. put/call ratio : ratio of no of puts/no of calls. data available in news papers. more puts indicate bearish sentiment (remember puts give positive payoffs in case market declines)

Wherease technical analysis focusses on market inefficiencies and data patterns, fundamental analysis focusses heavily on accounting numbers, economic indicators. Which type of analysis best suits/convinces you is up to you to decide and test !

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