Saturday, March 30, 2019

Different types of investment approaches

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Normally there are two different approaches to investing in stock market. One is based on the market price and the other is based on the intrinsic value of the stock. 

Those who follow the first approach are called Traders and those who follow the second approach are called investors. 

The diagram below explains the classification

Traders look at the current price and decide on the next action based on how they think the price will move today, tomorrow, next week or next month. They will say for example, the current price is 40, this stock has a potential to move to 44. Buy it with a stop loss of 38 (which means I don't know if I will be right. In case I am wrong, get the hell out quickly)

The analytical approach they follow is called Technical Analysis. The only parameter is the expected short term price movement. They use words like resistance and support very regularly. 

Investors follow the valuation approach. For them decision parameter is the intrinsic value of the stock. This approach is called fundamental analysis. There are two flavours to the Value approach. One is to look at the current value and compare it with the current price. The investors who follow this approach are called Value Investors. They look for good companies with great track record that are undergoing temporary difficulties. Once they find such companies, they analyze the cause for the downturn, and if it is temporary in their opinion, they will make a decision to buy the shares of the company. Once they find that the price is trading well below the intrinsic value, they buy the stock and then wait for the company to tide over the uncertainty and the market to 'discover' the intrinsic value. Once the price exceeds the intrinsic value, the value investor exit the share.

There are other types of value investors. They look for companies in businesses that are expected to perform well in the future. The current price of these companies may be well above the intrinsic value, but these investors feel that the current price is low in comparison to the growth potential of the company. These investors are known as Growth Investors and they follow 'Growth Investing'. 

The main difference between Value Investing and Growth Investing is that Value Investor looks for companies with established track record of performance, while the Growth Investor looks for potential spurt in performance. This approach is riskier just because the expected growth might not materialize and rewards the investor spectacularly if this growth does indeed materialize. 

Every one of us has a favourite approach. What is yours?

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