Investment Analysis 670
Photo by: Sergej Khakimullin

Investment analysis is an ongoing process of evaluating current and potential allocations of financial assets and choosing those allocations that best fit the investor's needs and goals. The two opposing considerations in investment analysis are growth rate and risk, which are usually directly proportionate in any given investment vehicle. This means that investments with a high degree of certainty, such as U.S.Treasury securities, offer a very modest rate of return (e.g., 5 percent annually), whereas high-risk stock investments could double or quadruple in value over a few months. Through investment analysis, investors must consider the level of risk they're able to tolerate and choose investments accordingly.

Beyond weighing the return of an individual investment, investors must also consider taxes, transaction costs, and opportunity costs that erode their net return. Taxes, for instance, may be reduced or deferred depending on the type of investment and the investor's tax status. Transaction costs may be incurred each time an individual purchases or sells shares of stock or mutual funds. These fees are usually a percentage of the dollar amount being transferred. Such fees may sift 3-6 percent or more off the initial investment and final return. If they don't seem warranted, such expenses may be avoided by choosing no load mutual funds and dealing with discount brokers, for instance. Much more nebulous is opportunity cost, which is what the investment could have earned had it been deployed elsewhere. Opportunity cost is largely the downside of investing too conservatively given one's means and circumstances. Again, both risk and growth factor into opportunity costs. For example, low risk comes at a price of low returns, but it may be worth the lost opportunity if the investor is retired and will be depending on the invested funds for living expenses in the near future.


Among the lowest risk—and lowest return—investments are interest-bearing notes such as money market funds, certificates of deposit from banks and U.S. Treasury bills, notes, and bonds. These pay the investor a guaranteed periodic interest payment, or, in the case of T-bills, a lump sum based on a guaranteed discount rate. To choose between the various options the investor need only consider the comparative interestrate (some pay more than others) and the term (many of these investments are based on fixed periods such as three months or a year). These sorts of investments are popular because they are fairly liquid—they can be bought and sold at any point in a financial cycle without adverse timing effects—and they offer a nearly risk-free option for investors who need certainty of return.


Mutual funds lure investors with the promise of stock market-like returns in a lower risk and more novice-friendly environment. These funds pool their members' investments in professionally managed portfolios of stocks, bonds, and other investments. As a result, they can provide individual investors with the kind of investment diversification that would otherwise require a much greater amount of money to be invested and much more effort in reviewing the many choices. In the 1980s and 1990s mutual funds were increasingly used for employee-managed retirement savings programs such as 401(k) plans.

Most funds have an investment objective and, as with stocks, the choices range from conservative, low risk funds that mirror a market index like the Standard & Poor's 500 to high-stakes aggressive growth funds that focus on small and unproven companies. Also like stocks, many funds perform poorly in a given year or even over a period of years, a fact that fund marketers sometimes gloss over. Thus choosing mutual funds involves many of the same considerations as choosing stocks.


While investments like oil futures and options are often seen as some of the riskiest forms of investment, ironically a key use for these market-traded contracts is for hedging against adverse movements in cash markets. In other words, investors buy futures or options contracts in part to reduce their risk of facing a devastating price fall (or increase, as the case may be) in another market. Collectively, futures, options, and similar instruments are known as derivatives because they derive from price movements in other markets, including commodities, currencies, and stocks. Of course, many investors also use derivatives for speculation. By nature the individual contracts are short-term investments, although some investors, mainly corporations and other institutions, maintain a regular portfolio of derivatives on underlying commodities or assets that affect their business.

Analyzing futures and options involves analyzing the expected direction of price movements for the underlying goods. However, in contrast to stock or mutual fund analysis, which is usually best done with an eye to the long term, derivative analysis requires making a short-term (less than a year) forecast of what might happen to prices in the cash markets. If the forecast proves accurate the investor can make money, but if it's wrong the losses could be substantial. With the practice of buying on margin, which involves taking out a loan to increase the amount of the investment, the profits or losses can be multiplied.


A security is a financial asset representing a claim on the assets of the issuing firm and on the profits produced by the assets. The term security analysis pertains to the process of identifying desirable investment opportunities in such financial assets. In the case of corporate stocks and bonds, the analysis flows from the interpretation of accounting and financial data regarding operations, profitability, net worth, and the like. Investment alternatives are identified based on (1) the investor's risk/reward ratio, (2) a specified time horizon, and (3) current market prices.

Security analysts, in essence, are the catalysts which drive the efficient market hypothesis. That is, "smart" money will logically and efficiently distribute itself in such a way that security prices reflect all available information. As new information becomes available, analysts assess it and recommend market price adjustments according to changes they anticipate for price levels. The cumulative impact of price adjustments moves the market to equilibrium so that the price of any security approximates true investment value.

Security analysts operate in three arenas, each reflecting a different set of goals and objectives. Investment banking and brokerage firms represent the "sell" side of security analysis. Their clients are fee and commission paying institutional and individual investors.

Investment management organizations conduct security analysis for the portfolios they manage. Since portfolio managers purchase securities, they represent the "buy" side of the street.

Finally, a number of investment publishing services provide security analysis for all investors subscribing to their reports. The most popular investment services are available through Value Line Inc., Standard & Poor's, Moody's Investors Service, and Dun & Bradstreet.


There are two basic methodologies: fundamental analysis and technical analysis. In their own way, each approaches investment decisions from the top-down and from the bottom-up.


The top-down approach, the traditional methodology, begins with a broad perspective and ends with a specific analysis of a stock or a bond. The top-down approach initially analyzes macroeconomic data, filters it into more specific sectors, and finally distills the results with respect to a specific security.

Analysts determine the important economic conditions and forces at work and their potential impact on the markets. Analysts examine corporate profitability, the direction and magnitude of interest rates, money supply, fiscal policy, employment, migration, export/import trends, etc., to evaluate the future performance of individual economic sectors and industries.

Security analysts also utilize the top-down approach to allocate available funds within portfolios between short-term and long-term investments, between risky and risk-free securities, and between stocks and bonds. Sector-to-sector and market-to-market comparisons purport to identify where investors should look for superior returns. Analysts recommend investing in favorable industries or sectors, and suggest specific stocks within each sector.


A major drawback to the top-down approach is the likelihood of overlooking certain stocks that offer significant investment opportunities but which are outside the favorable sectors. To remedy this, analysts also utilize the bottom-up approach which identifies superior performers without regard to industry.

This approach identifies advantageous investments according to performance and financial criteria. The criteria are applicable across industry and sectors, establishing performance and financial benchmarks which companies must meet or exceed in order to be considered. Analysts also develop criteria to separate the top performers by various degrees of risk, e.g., conservative versus aggressive.

Once the screens have filtered out the appropriate securities, the analyst conducts a fundamental analysis of the company.


Fundamental analysts look for superior returns from securities that are mispriced by the market. To identify them the analyst engages in various calculations using data from financial statements and balance sheets to determine the future earnings and dividends of a company, the degree to which these exceed the expected average for the industry, and the potential for the stock to move closer to a correct or fair value. Fundamental analysts would recommend buying undervalued, or underpriced, stocks. When a stock is believed to be overvalued, the analyst would advise selling or taking a short position because the market would be expected to correct the price downward in the future.


Some of the external conditions affecting a company's performance are:

  1. Demographic changes: sex, age, absolute numbers, location, population movements, educational preparation.
  2. Economic conditions: employment level, regional performance, wage levels, spending patterns, consumer debt, capital investment.
  3. Government fiscal policy and regulation:spending levels, the magnitude of entitlements, debt, war and peace, tax policies, environmental regulations.
  4. Competition: market penetration and position, market share, commodity, commodities marketing strategies, and niche products.
  5. Vendors: financial soundness, quality and quantity of product, R&D capabilities, alternative suppliers, just-in-time capabilities.

Industry- and firm-specific characteristics important to the fundamental analyst are: profitability; market presence; productivity; product type, sales, and services; financial resources; physical facilities; research and development; quality of management.

The analyst approaches these indicators in two ways: first, as trends within an industry, and secondly as features of a particular firm. To do this, analysts use a series of ratios constructed from the financial statements. Ratios represent the percentage or decimal relationship of one number to another. Ratios facilitate the use of comparative financial statements, which provide significant information about trends and relationships over two or more years. Analysts compare a company's ratios to industry ratios, as well as cross-sectionally to other companies.

Structural analysis compares two financial statements in terms of the various items or groups of items within the same period. Time series analysis correlates ratios over time, measured in years or by quarters.

Since ratios are relative measures, they furnish a common scale of measurement from which analysts construct historical averages. Thus, analysts are able to compare companies of different sizes and from different industries based on performance and financial condition by (a) establishing absolute standards, (b) examining averages, and (c) using trends to forecast future results. To increase predictability, the analyst considers the impact of external factors on internal trends.


In 1934 Benjamin Graham and David Dodd published Security Analysis. This book is considered the bible of fundamental practitioners. In the 1920s, Graham became a successful portfolio manager by stressing capital preservation by investing proportionately in high quality stocks and in low risk credit instruments. With Dodd, his student from UCLA, Graham laid out vigorous investment procedures in the book.

Graham and Dodd primarily appraised stocks according to their earning power. They recommended an extensive list of financial ratios to measure a company's performance according to:

  1. Projected future earnings
  2. Projected future dividends
  3. A method for valuing expected earnings
  4. The value of the asset

In the belief that investors tended to overreact to near-term prospects, Graham and Dodd designed formulas to keep the disparity between P/E's for different companies within sharp focus. Analysts continue to apply these principles today.


Financial analysis is necessary in determining the future value of a company. Financial analysis concentrates on the condition of the financial statements: the income statement, the balance sheet, the statement of changes in shareholders' equity, and the funds flow statements. From these the analyst determines the values of the outstanding claims on the company's income.

Financial analysts measure past performance, evaluate present conditions, and make predictions as to future performance. This information is important to investors looking for superior returns. Creditors use this information to determine the risk associated with the extension of credit.


The most common method used by analysts is financial ratios. Composition ratios compare the size of the components of any accounting category with the total of that category, for example, the percentage of net income to net sales. Composition ratios:


Although widely used, financial analysis does have some fundamental weaknesses. Since it is based on data from financial reports, its findings are subject to distortions resulting from inflation, wild business swings, changes in accounting practices, and undisclosed inner-workings of the firm. Management can manipulate important key ratios by changing inventory valuations, depreciation schedules, and expense recognition practices. Furthermore, since the financial statements are static, the analyst cannot account for the impact of seasonal variations. Finally, the ratios are meaningless unless compared to performance benchmarks.


Technical analysis examines stock price trends in an attempt to predict future prices. Technical analysts believe that all the relevant information about economic fundamentals of an industry and of a stock are reflected in the direction and volume of prices. Therefore, technical analysts look to the past, for they believe that markets are cyclical, forming specific patterns, and these patterns repeat themselves over time. They further believe that it is only necessary to compare short-term and intermediate price movements to long-term trends in order to predict market direction.

Two major techniques form the basis of technical analysis: the study of key indicators, and the charting of market activity.


Common key indicators utilized by technical analysts include the following:

  1. Trading volume is based on supply-demand relationships and indicates market strength or weakness. Rising prices with increased buying generally signals uptrends. Decreasing prices with increasing demand, and increasing prices with decreasing volume, signal downtrends. Trading volume applies best to the short-term (three to nine months).
  2. Market breadth examines the activity of a broader range of securities than do highly publicized indices such as the Dow Jones Industrial Average. The breadth index is the net daily advances or declines divided by the amount of securities traded. The breadth index is calculated by either the number of securities, the dollar volume, or nominal volume. Breadth analysis concentrates on change rather than on level in order to evaluate the dispersion of a general movement in prices. The slope of the advance/decline line indicates the trend of the breadth index. Breadth analysis points to the prime turning points in bull and bear markets.
  3. Confidence indices evaluate the trading patterns of bond investors who are regarded as more sophisticated and more well-informed that stock traders and, therefore, spot trends more quickly. Other confidence theories measure the sentiment among analysts themselves, the breadth trends in options and futures trading, and consumer confidence. Analysts consider these to have predictive value in the near and intermediate term.
  4. The put-call ratio divides the volume of puts outstanding by the volume of calls outstanding. Investors generally purchase the greatest number of puts around market bottoms when their pessimism peaks, thus indicating a turnaround. Call volume is greatest around market peaks, at the heights of investor enthusiasm—also indicating a market turn.
  5. The cash position of funds gives an indication of potential demand. Analysts examine the volume and composition of cash held by institutional investors, pension funds, mutual funds, and the like. Because fund managers are performance driven, analysts expect them to search out higher returns on large cash balances and, therefore, will invest more heavily in securities, driving prices higher.
  6. Short selling represents a bearish sentiment. Analysts in agreement with short sellers expect a downturn in the market. Analysts particularly watch the action of specialists who make a market in a specific stock. In addition, analysts look at odd-lot short sellers who indicate pessimism with increased activity. However, many technical analysts express a "contrarian" view regarding short sales. These analysts believe short sellers overreact and speculate because of the potential profits involved. In addition, to close their positions, short sellers will purchase the securities in the future, thus putting upward pressure on prices. Short selling analysis is based on month-to-month trends.
  7. Odd-lot theory follows the trends of transactions involving less than round lots (less than 100 shares). This theory rests on a contrarian opinion about small investors. The theory believes the small trader is right most of the time, and begins to sell into an upward trend. However, as the market continues to rise, the small investor re-enters the market as the sophisticated traders are bailing out in anticipation of a top and a pull back. Therefore, an increase in odd-lot trading signals a downturn in the market.

Odd-lot indices divide (1) odd-lot purchases by odd-lot sales, (2) odd-lot short sales by total odd-lot sales, and (3) total odd-lot volume (buys + sales) by round-lot volume.


Charting is useful in analyzing market conditions and price behavior of individual securities. Standard & Poor's Trendline is a well known charting service which provides data on companies. This data shows the trend of prices, insider sales, short sales, and trading volume over the intermediate and long-term. Analysts have plotted this data on graphs to form line, bar, and point-and-figure charts.

Chart interpretation requires the ability to evaluate the meaning of the resulting formations in order to identify ranges in which to buy or sell. Charting assists in ascertaining major market downturns, upturns, and trend reversals.

Analysts use moving averages to analyze intermediate and long-term stock movements. They predict the direction of prices by examining the trend in current prices relative to the long-term moving average. A moving-average depicts the underlying direction and degree of change.

The relative strength of an individual stock price is a ratio of the average monthly stock price compared to the monthly average index of the total market or the stock's industry group. It informs the analysts of the relationship of specific price movements to an industry or the market in general. When investors favor specific stocks or industries, these will be relatively strong. Stocks that outperform the market trend on the upside may suddenly retreat when investors bail out for hotter prospects. Stocks that outperform in a declining market usually attract other investors and remain strong.

As analysts construct charts, certain trends appear. These trends are characterized by a range of prices in which the stock trades.

The lower end of the range forms a support base for the price. At that end a stock is a "good" buy and attracts additional investors, and thus forms a support level. As the price increases, a stock may become "unattractive" when compared to other stocks. Investors sell causing that upper limit to form a resistance level. Movements beyond the support and resistance levels require a fundamental change in the market and/or the stock.


Random-walk theorists do not believe in the cyclical nature of markets although they analyze the same data as do chartists. Random walk theory maintains that technical analysis is useless because past price and volume statistics do not contain any information by themselves that bode well for success. Random walkers believe choosing securities randomly will result in returns comparable to technical and fundamental analysis.

Through a series of illustrations, academicians in the 1960s and 1970s demonstrated that there is no basis in fact for technical analysis. They found that price movements were random and displayed no predictable pattern of movement, as did the Frenchman Louis Bachelier at the turn of the century. Therefore, prices have no predictive value. Since all the studies indicated randomness in price, the proponents of this hypothesis called it the "random walk theory."

Random walkers use time-series models to relate efficient markets to the behavior of stock prices and investment returns. They believe that changes in prices are independent of new information entering the market, and that these prices changes are evenly distributed throughout the market. Since this means that the distribution of price changes is constant from one period to the next, investors are not able to identify "mispriced" securities in any consistent fashion. Experience and empirical evidence contradict this assumption, suggesting that the random walk properties of returns (or price changes) are too restrictive.

Technicians maintain the validity of their practices especially with regards to the timing of investments. Since computer-based trading programs incorporate some timing technique into their matrix, intra-day trading has increasingly become characterized by dramatic movements in the indices. These movements represent a consensus among traders of the applicability of technical theories despite of the evidence of random walkers. A market driven by similarly configured indices, no matter what the basis, becomes more predictable over time.

In practice, computer programs execute trades not only in anticipation of a market move, but to provide fund managers the opportunity to change positions ahead of the others.


Although Charles Dow—publisher of the Wall Street Journal —was a fundamentalist, he published a series of articles which laid the foundation for William P. Hamilton's 1908 work that formalized the Dow Theory. Hamilton theorized that the stock market is the best gauge of financial and business activity because all relevant information is immediately discounted in the prices of stocks, as indexed by the Dow Jones Industrial Average and the Dow Jones Transportation Average. Accordingly, both averages must confirm market direction because price trends in the overall market points to the termination of both bull and bear markets.

Three movements are assumed to occur simultaneously:

  1. A primary bull or bearish trend, typically lasting 28 to 33 months.
  2. A secondary trend goes counter to the primary trend, typically lasts three weeks to three months, and reflects a long-term primary movement.
  3. Day-to-day activity makes up the first two movements of the market, confirming the direction of the long-term primary trend.

The primary trend must be supported by strong day-to-day activity to erase the effects of the secondary trend, otherwise, the market will begin to move in the opposite direction. If day-to-day activity supports the secondary trend, the market will soon reverse directions and develop a new primary trend.

If the cyclical movements of the market averages increase over time, and the successive lows become higher, the market will trend upward. If the successive highs trend lower, and the successive low trend lower, then the market is in a downtrend. Computer programs have fully integrated Dow theory into their decision-making matrix.

SEE ALSO : Portfolio Management Theory ; Valuation


Bauer, Richard J., and Julie R. Dahlquist. Technical Market Indicators: Analysis & Performance. New York: John Wiley & Sons, 1998.

Journal of Portfolio Management, quarterly.

Konoshi, Atsuo, and Ravi E. Dattatreya, eds. The Handbook of Derivative Instruments. Chicago: Irwin Professional Publishing, 1996.

Radcliffe, Robert C. Investment: Concepts, Analysis, Strategy. Reading, MA: Addison-Wesley Publishing Co., 1996.

Woolley, Suzanne. "Technicians Take Center Stage." Business Week, 19 October 1998.

User Contributions:

Comment about this article, ask questions, or add new information about this topic: