Summary and Next Steps
Congratulations! You've made it through Step One of Investing Basics. (Bet you didn't even break a sweat.) You've witnessed the power of compounding and you understand how debt (and other common pitfalls) can ruin even the healthiest investing plan. Empowered with a general sense of the various savings and investing vehicles, you are now prepared to look at the basic investment concepts.
The Investment Process
What is investing? Any time you invest, you are putting something of yours into something else in order to achieve something greater. You can invest your weekends in a good cause, you can invest your intelligence in your job, or you can invest your time in a relationship. Just as you do each of these with the expectation that something good will come of it, when you invest your savings in a stock, bond, or mutual fund, you do so because you think its value will appreciate over time.
Investing money is putting that money into some form of "security" - a fancy word for anything that is "secured" by some assets. Stocks, bonds, mutual funds, certificates of deposit - all of these are types of securities. As with anything else, there are many different approaches to investing. Some of these you've probably seen on late-night TV. A well-dressed, wildly positive (though somewhat whiny) young man sits lazily waving palm fronds and shakes his head over how incredibly easy it is to amass vast wealth - in no time at all! Well, hey! That sounds fine! However, discerning minds will wonder: If it were so easy, wouldn't everyone who saw the same pitch be rich? Then, too, you always have to send some money to learn the secrets. So we suggest you take the $25 you'd spend on the hardcover EZ Secrets to Untold Billions book and the $500 you would shell out for the EZ Seminar, and invest it yourself - after you've learned the basics here.
Time Value of Money
Is a dollar always worth a dollar? OK, you sly fox - you caught us, it's a trick question! And you guessed it - a dollar is not always worth a dollar. Sometimes a dollar is only worth 80 cents, and sometimes it is worth $1.20. (Say! You give us your dollars worth $1.20, and we'll give you ours worth $0.80, in an even trade! Have we got a deal?)
But let's think about this. How can it be? The value of a dollar changes dramatically depending on when you can take control of the dollar and invest it. The critical variable in the exact value of a dollar is time.
If someone owes you a dollar, do you want him to pay you today or next year? (Yes! Another trick question! The answer is, "Today.") With inflation consistently destroying the purchasing power of a dollar, a year from now a dollar will be worth slightly less than it is today. "Inflation" is an economic term used to describe the gradual tendency of prices to rise over time. If inflation is 2% per year, that means that prices, on average, will rise 2% over the next year, which in turn means that your dollar can purchase 2 cents less in a year than it can today. That's right, all you mathematicians out there - with 2% inflation, a dollar today is worth only 98 cents in a year.
However, if you got the dollar back today, you could invest it. If you invested it (along with a few of its cousins, we hope) in the stock market, and your investment returned 10% over the course of the year (which is somewhat less than the market average has historically returned), then you'd have $1.10 at the end of the year. So your money would be growing instead of shrinking, and you'd be staving off the negative effects of inflation.
The Miracle of Compounding
In fact, if you leave this dollar invested, its value will mushroom over time through the miracle of compounding. As we discussed back in Step 1. Getting Started, as you earn investment returns, your returns begin to gain returns as well, allowing you to turn a measly dollar into thousands of dollars if you leave it invested long enough.
The more money you save and invest today, the more you'll have in the future. Real wealth, the stuff of dreams, is in fact created almost magically through the most mundane and commonplace principles: patience, time, and the power of compounding. To heck with your lousy odds in the lottery or with someone's "Wealth in Nanoseconds!" pitch.
Look at it another way -- if you were to take a mere $20 a week and put it into an index fund, then at the end of 40 years, assuming a modest 12% return, you would have just over a million bucks. In short, you would basically have won the lottery -- for $20 a week, or a total of $40,800 out-of-pocket along the way.
We like those odds.
Compounding is so miraculous that even at relatively low returns you can double and triple your money over long periods of time. When someone brags about doubling his money in 10 years, for instance, you shouldn't just smile and nod about how great he did. You only need a 7.1% annual return to double your money in 10 years. If the Standard and Poor's 500, a widely used barometer of the stock market, has gone up 10.6% a year, the poor fellow who doubled his money in ten years has actually underperformed the market. So now the trick becomes: In order to increase your money, how could you invest it so that it outperforms the market? (We'll learn more about finding good investments in Step 6. Analyzing Stocks.)
Now, let's say your investments earned 10% last year. How much did you really make? Well, the last time we checked the taxman wants to grab a piece of what you earn. One of the most significant factors investors tend to leave out when assessing their investment returns is the tax consequence. Even if you have a long-term capital gain that is only taxed at 20%, a 10% return quickly becomes 8%. And for short-term gains, the tax bite is even greater. At any rate, the question of importance for you is: "How much do I end up with at the end of the day?"
Another factor that affects returns, as we mentioned above, is inflation. So if your investments made 10% after taxes last year and inflation reduced your principal's buying power by 2%, then you actually only made a real return of 8%. All you need to do is to take your annualized after-tax return and subtract the annual rate of inflation. How can you find out what inflation was? Every quarter the government reports the Consumer Price Index (CPI), which is what most investors use as a proxy for general inflation at the consumer level. You can find it in your local newspaper's business section or at the Bureau of Labor Statistics.
Investing Versus Speculating
About now you may be sitting back thinking about your brother-in-law who "made a killing" in options. Or maybe you're reminiscing about that Nevada vacation when one lucky quarter magically drew out 700 more with the pull of a slot machine lever. Why put your money in slow-and-steady investment vehicles that merely promise double-digit returns when you could have near-instant riches? With compounding, you have to wait patiently for years for your riches to accumulate. What if you want it all now?
Granted, there is nothing exhilarating about predictability. Sure, tales of your fifth year beating the performance of the Standard and Poor's 500 Index won't make you the life of the party. However, neither will the far more common tales about how you lost your savings on some speculation, and your subsequent adventures in bankruptcy court. (Actually, that might make for some entertaining party chatter, especially given our penchant for reveling in the misery of others. But let's try for the moment to ignore sad musings about human nature.)
What are the odds of winning the lottery jackpot? Well, it depends on the lottery - they may be 1 in 7 million, or 1 in 18 million, or somewhere in between. You have a far greater chance of dying from flesh-eating bacteria - 1 in a million - than you do of winning that jackpot!
You don't need a card dealer, dour strangers, or Wayne Newton background muzak to gamble. There are plenty of stock market gamblers who do an admirable job of losing their money on seemingly legitimate pursuits. At the Motley Fool we think that commodities and options are just as risky as a Vegas craps game. In fact, we believe investors "gamble" every time they commit money to something they don't understand.
This, of course, may be true of stocks as well as of commodities and options. Say you overhear your best friend's dentist's nanny talking about a company called Huge Fruit at a cocktail party. "This thing is gonna go through the roof in the next few months," she says in a stage whisper. If you call your broker the first thing the next morning to place an order for 100 shares, you've just gambled. Do you know what Huge Fruit does? Are you familiar with its competition (Heavy Melon)? What were its earnings last quarter? There are a lot of questions you should ask about a company before you throw your hard-earned cash at a "hot" stock. There's nothing too hot about losing your money because you didn't take the time to understand what you were investing in.
Remember: Every dollar that you speculate with and lose is a dollar that is not working for you over the long-term to create wealth. Speculation promises to give you everything you want right now but rarely delivers; patience almost guarantees those goals down the road.
Planning and Setting Goals
Investing is like a long car trip. There's a lot of planning that goes into it.
How long is the trip? (What is your investing "time horizon"?)
What should you pack? (What type of investments will you make?)
How much gas will you need? (How much money will you need to reach your goals?)
Will you need to stop along the way? (Do you have short-term financial needs?)
How long do you plan on staying? (Will you need to live off the investment in later years?)
Running out of gas, stopping frequently to visit restrooms, and driving without sleep (this is the last of the travel analogy, we promise) can ruin your trip. So can saving too little money, investing erratically, or, as we said in Step One, doing nothing at all.
You must answer the following questions before you can successfully set about your savings/investing journey:
What are your goals? Is this money for retirement? A down payment on a house? Your child's education? A second home? Income to live on in the proverbial Golden Years?
How much money can you devote to a regular investing plan?
Don't let yourself get away with fuzzy answers, either. In the end, investing is a lot of numbers. You need to get used to that, and quickly. As a matter of fact, it can be quite liberating. You can see exactly what you need to get to your destination, and can be accountable to yourself along the way. Ask yourself some more pointed questions:
How much will college cost when my child needs to go?
How much yearly income is reasonable for retirement?
Don't worry ... you don't have to do all the math yourself. There are online interactive calculators available that can help you figure your future money needs. The more specific you can be, the more likely you are to set and achieve reasonable goals.
After you have a rough idea of how much money you'll need and how much time you have to get there, you can start to think about what investment vehicles might be right for you and what kind of returns you can reasonably expect.
Time Is on Your Side
To help put this into context, let's look at how various types of investments have performed historically. Bonds and stocks are the two major asset classes that have been used by investors over the past century. Knowing the total returns on each of these, and their associated volatility, is crucial to deciding where you should put your money.
Putting your money into cash reserves - U.S. Treasury bills, or more recently, money market funds - has yielded roughly 4.2% per year during this century, according to Global Financial Data. While this may not seem like a lot today, it is important to remember that for most of this century, inflation was nonexistent, making a 4.2% average annual return attractive until the 1960s. Though it is interesting that cash reserves have outperformed bonds this century, if one expands the time frame back to 1802, cash returns trail the return of bonds, and during the 1980s and 1990s, cash reserves have consistently trailed bond returns.
Long-term government bonds have returned around 4.0% per year since 1900; surprisingly, they're not that superior to short-term bonds. The best decade for bonds in the past century was the 1980s, when bonds returned 13.81% annually. The worst was the 1950s, when bonds lost -3.75%. Had you invested $1 in long-term bonds in 1900, you would have about $50 today.
Stocks have also been very good to investors. Overall, stocks have returned an average of 9.8% per year since 1900 - quite a bit higher than bonds. Surprisingly, the range of the returns for stocks is not that much larger than the range for bonds over the same period. According to Global Financial Data, the worst return in one decade was the 1930s, when stocks declined 0.17% per year, including dividends. The best decades have been the 1950s, when stocks increased by 18.23% annually; the 1980s, when stocks increased by 16.64% annually; and the 1990s, during which stocks have increased by 17.3% annually. Had you put $1 into stocks in 1900, you would have over $10,000 today.
Determining Your Investment Style
What kind of investor are you? Are you a swing-for-the-fences type, or are you content hitting singles and doubles, racking up slow and steady gains? Or do you prefer to sit in the stands, chatting with your companions and occasionally cheering your home team on?
Before you start investing, you should determine your investment style. There are two major variables in figuring out your investment style - your risk tolerance and the amount of time you can dedicate to investing.
Risk. How comfortable will you be if you invest in something in which the price changes every day - sometimes not the way you want it to change? There are various degrees of risk across the investment spectrum, from government bonds, which are considered risk-free as they are guaranteed by the government, to commodities and options, where you can and often do lose all of your money.
You need to consider how comfortable you will be seeing your investment decrease in the near term while you wait for it to increase over the long term. Although stocks have historically increased in price over the past two centuries, there have been some pretty bad periods. Without counting dividends, your equity investments could have lost almost 80% of their value had you bought stocks at the high in 1929 before the crash. You could have lost 40% had you bought at the high in 1972. Heck, in October of 1987 the Dow decreased 25% - in just one day! The important thing to remember about stocks, though, is that you don't lose anything until you sell them. For example, if you didn't panic and sell your stocks in October of 1987, you did quite nicely as the market rebounded in subsequent years. That's why, when you're investing in the stock market, you need to think long-term. Don't invest any money in stocks that you'll need in the short term.
Government bonds provide guaranteed returns, and bank savings accounts are insured by the Federal Deposit Insurance Corporation (FDIC). For stock investing, there is no similar guarantee or insurance that the ride will be smooth or that every investment will make you money, but if you buy good businesses and hold for the long term, the odds are in your favor. Just remember that the safest road isn't always the best one. At the Motley Fool we believe that the biggest risk is not taking enough risk, meaning not investing enough in stocks.
It should also be said that you can learn to increase your risk tolerance for investing in stocks. Once you see the kind of returns you can generate over time, you'll come to realize that it really doesn't matter if your stock drops or rises over the course of a few hours or days or weeks or even months. It may be fun to check your stock prices (and it's so easy on the Internet!) but it doesn't mean much over the long term.
Time. Speaking of the long term, time is another important element of your investing profile. How much time do you want to spend on investing? How active do you want to be in the management of your money? Do you want to spend 15 minutes a year on it? Then maybe you should consider using the Passive Strategies detailed below. Or maybe you have eight hours a week, in which case you might enjoy researching companies and poring over financial statements to pick individual stocks.
Another time factor is: When do you need the money? As we will discuss in Step 8. Keys to Success, whether you need the money next week or in a hundred years will dramatically affect what investment vehicle you decide to use. Although stocks have great long-term returns, the returns over periods of three years or less can be downright scary. Luckily for you, as you have now determined your goals and how much money you will need to get there, you also know how soon you will need the money and will be able to make the appropriate choices when you are ready to invest.
Active and Passive Strategies
The two main methods of investing in stocks are called active and passive management. No, active investors aren't the ones who exercise and eat leafy greens while passive investors watch too much TV and eat junk food. Instead, the distinction between active and passive investing is whether you (or whoever manages your money) actively choose the companies in which you invest or whether your investments are determined by some index created by a third party.
Active investing is what most people mean when they talk about stock investing. Whether they do it, their broker does it, or a mutual fund manager does it, the money is managed "actively." The hardest part about making the case for passive investing is convincing people that active investing may not always be all that it is cracked up to be. According to Lipper Analytical Services, over the five years ended in June 1998, 90% of "general equity" mutual funds, meaning garden variety stock funds, underperformed the Standard and Poor's 500 Index - the major benchmark for stock mutual funds.
With 9 out of 10 equity mutual funds failing to beat the market average over five years, you can understand why some people want an alternative to "active" management. Many people who just want a return equal to that of a major stock index use passive investing as a way to do this. The most famous passive investment strategy is investing in the Standard and Poor's 500 Index, also known as the S&P 500, although the Russell 2000, the Wilshire 5000, and various international indexes are also used for passive investment options.
Summary and Next Steps
Now you have figured out your goals, set your investment horizon, thought about your investment style, and considered whether or not to use active or passive investment strategies. You have come a long way from the tow-headed investment novice we met in Step One. At this point you may decide that investing in an S&P 500 Index mutual fund or the Dow Dividend Approach is the best investing course for you. But if you have aspirations of more actively managing your money or are curious about how doing so might improve your returns, please join us in Step 3. Stocks as we learn about stocks.
Investing, like most other things, requires that you have a general philosophy about how to do things in order to avoid careless errors. Would you make a souffle without a recipe? Would you play cello in the London Philharmonic Orchestra without sheet music? Would you aim a shuffleboard disk without figuring out whether you're trying to knock off your own color or your opponent's? We hope not. And while investing is not nearly as difficult as these other challenges (especially the souffle), you certainly need a considered plan before investing your hard-earned savings.
Fundamental Analysis - Buying a Business (Value, Growth, Income, GARP, Quality)
Many people rightly believe that when you buy a share of stock you are buying a proportional share in a business. As a consequence, to figure out how much the stock is worth, you should determine how much the business is worth. Investors generally do this by assessing the company's financials in terms of per-share values in order to calculate how much the proportional share of the business is worth. This is known as "fundamental" analysis by some, and most who use it view it as the only kind of rational stock analysis.
Although analyzing a business might seem like a straightforward activity, there are many flavors of fundamental analysis. Investors often create oppositions and subcategories in order to better understand their specific investing philosophy. In the end, most investors come up with an approach that is a blend of a number of different approaches. Many of the distinctions are more academic inventions than actual practical differences. For instance, value and growth have been codified by economists who study the stock market even though market practitioners do not find these labels to be quite as useful. In the following descriptions, we will focus on what most investors mean when they use these labels, although you always have to be careful to double-check what someone using them really means.
Value. A cynic, as the saying goes, is someone who knows the price of everything and the value of nothing. An investor's purpose, though, should be to know both the price and the value of a company's stock. The goal of the value investor is to purchase companies at a large discount to their intrinsic value - what the business would be worth if it were sold tomorrow. In a sense, all investors are "value" investors - they want to buy a stock that is worth more than what they paid. Typically those who describe themselves as value investors are focused on the liquidation value of a company, or what it might be worth if all of its assets were sold tomorrow. However, value can be a very confusing label as the idea of intrinsic value is not specifically limited to the notion of liquidation value. Novices should understand that although most value investors believe in certain things, not all who use the word "value" mean the same thing.
The person viewed as providing the foundation for modern value investing is Benjamin Graham, whose 1934 book Security Analysis (co-written with David Dodd) is still widely used today. Other investors viewed as serious practitioners of the value approach include Sir John Templeton and Michael Price. These value investors tend to have very strict, absolute rules governing how they purchase a company's stock. These rules are usually based on relationships between the current market price of the company and certain business fundamentals. Some examples include:
Price/earnings ratios (P/E) below a certain absolute limit
Dividend yields above a certain absolute limit
Book value per share at a certain level relative to the share price
Total sales at a certain level relative to the company's market capitalization, or market value
Growth. Growth investing is the idea that you should buy stock in companies whose potential for growth in sales and earnings is excellent. Growth investors tend to focus more on the company's value as an ongoing concern. Many plan to hold these stocks for long periods of time, although this is not always the case. At a certain point, "growth" as a label is as dysfunctional as "value," given that very few people want to buy companies that are not growing. The concept of growth investing crystallized in the 1940s and the 1950s with the work of T. Rowe Price, who founded the mutual fund company of the same name, and Phil Fisher, who wrote one of the most significant investment books ever written, Common Stocks and Uncommon Profits.
Growth investors look at the underlying quality of the business and the rate at which it is growing in order to analyze whether to buy it. Excited by new companies, new industries, and new markets, growth investors normally buy companies that they believe are capable of increasing sales, earnings, and other important business metrics by a minimum amount each year. Growth is often discussed in opposition to value, but sometimes the lines between the two approaches become quite fuzzy in practice.
Income. Although today common stocks are widely purchased by people who expect the shares to increase in value, there are still many people who buy stocks primarily because of the stream of dividends they generate. Called income investors, these individuals often entirely forego companies whose shares have the possibility of capital appreciation for high-yielding dividend-paying companies in slow-growth industries. These investors focus on companies that pay high dividends like utilities and real estate investment trusts (REITs), although many times they may invest in companies undergoing significant business problems whose share prices have sunk so low that the dividend yield is consequently very high.
GARP. GARP, aside from being the name of the title character to John Irving's The World According to Garp, is an acronym for growth at a reasonable price. The world according to GARP investors combines the value and growth approaches and adds a numerical slant. Practitioners look for companies with solid growth prospects and current share prices that do not reflect the intrinsic value of the business, getting a "double play" as earnings increase and the price/earnings (P/E) ratios at which those earnings are valued increase as well. Peter Lynch, who may be familiar to you through his starring role in Fidelity Investments commercials with Lily Tomlin and Don Rickles, is GARP's most famous practitioner.
One of the most common GARP approaches is to buy stocks when the P/E ratio is lower than the rate at which earnings per share can grow in the future. As the company's earnings per share grow, the P/E of the company will fall if the share price remains constant. Since fast-growing companies normally can sustain high P/Es, the GARP investor is buying a company that will be cheap tomorrow if the growth occurs as expected. If the growth does not come, however, the GARP investor's perceived bargain can disappear very quickly.
Because GARP presents so many opportunities to focus just on numbers instead of looking at the business, many GARP approaches, like the nearly ubiquitous PEG ratio and Jim O'Shaughnessy's work in What Works on Wall Street are really hybrids of fundamental analysis and another type of analysis -- quantitative analysis.
Quality. Most investors today use a hybrid of value, growth, and GARP approaches. These investors are looking for high-quality businesses selling for "reasonable" prices. Although they do not have any shorthand rules for what kind of numerical relationships there should be between the share price and business fundamentals, they do share a similar philosophy of looking at the company's valuation and at the inherent quality of the company as measured both quantitatively by concepts like Return on Equity (ROE) and qualitatively by the competence of management. Many of them describe themselves as value investors, although they concentrate much more on the value of the company as an ongoing concern rather than on liquidation value.
Warren Buffett of Berkshire Hathaway is probably the most famous practitioner of this approach. He studied under Benjamin Graham at Columbia Business School but was eventually swayed by his partner, Charlie Munger, to also pay attention to Phil Fisher's message of growth and quality.
Arguments Against Fundamental Analysis. Those who do not use fundamental analysis have two major arguments against it. The first is that they believe that this type of investing is based on exactly the kind of information that all major participants in publicly traded markets already know, so therefore it can provide no real advantage. If you cannot get a leg up by doing all of this fundamental work understanding the business, why bother? The second is that much of the fundamental information is "fuzzy" or "squishy," meaning that it is often up to the person looking at it to interpret its significance. Although gifted individuals can succeed, this group reasons, the average person would be better served by not paying attention to this kind of information.
Quantitative Analysis - Buying the Numbers
Pure quantitative analysts look only at numbers with almost no regard for the underlying business. The more you find yourself talking about numbers, the more likely you are to be using a purely quantitative approach. Although even fundamental analysis requires some numerical inputs, the primary concern is always the underlying business, focusing on things like management's expertise, the competitive environment, the market potential for new products, and the like. Quantitative analysts view these things as subjective judgments, and instead focus on the incontrovertible objective data that can be analyzed.
One of the principal minds behind fundamental analysis, Benjamin Graham, was also one of the original proponents of this trend. While running the Graham-Newman partnership, Graham exhorted his analysts to never talk to management when analyzing a company and focus completely on the numbers, as management could always lead one astray.
In recent years as computers have been used to do a lot of number crunching, many "quants," as they like to call themselves, have gone completely native and will only buy and sell companies on a purely quantitative basis, without regard for the actual business or the current valuation - a radical departure from fundamental analysis. "Quants" will often mix in ideas like a stock's relative strength, a measure of how well the stock has performed relative to the market as a whole. Many investors believe that if they just find the right kinds of numbers, they can always find winning investments. D. E. Shaw is widely viewed as the current King of the Quants, using sophisticated mathematical algorithms to find minute price discrepancies in the markets. His partnership sometimes accounts for as much as 50% of the trading volume on the New York Stock Exchange in a single day.
Company Size. Some investors purposefully narrow their range of investments to only companies of a certain size, measured either by market capitalization or by revenues. The most common way to do this is to break up companies by market capitalization and call them micro-caps, small-caps, mid-caps, and large-caps, with "cap" being short for "capitalization." Different-size companies have shown different returns over time, with the returns being higher the smaller the company. Others believe that because a company's market capitalization is as much a factor of the market's excitement about the company as it is the size, revenues are a much better way to break up the company universe. Although there is no set breakdown used by all investors, most distinctions look something like this:
MICRO - $100 million or less
SMALL - $100 million to $500 million
MID - $500 million to $5 billion
LARGE - $5 billion or more
The majority of publicly traded companies fall in the micro or small categories. Some statisticians believe that the perceived outperformance of these smaller companies may have more to do with "survivor" bias than actual superiority, as many of the databases used to do this performance testing routinely expunged bankrupt companies until pretty recently. Since smaller companies have higher rates of bankruptcy, excluding this factor helps "juice" up their historical returns as a result. However, this factor is still being debated.
Screen-Based Investing. Many quantitative analysts use "screens" to select their investments, meaning that they use a number of quantitative criteria and examine only the companies that meet these criteria. As the use of computers has become widespread, this approach has increased in popularity because it is easy to do. Screens can look at any number of factors about a company's business or its stock over many time periods.
While some investors use screens to generate ideas and then apply fundamental analysis to assess those specific ideas, others view screens as "mechanical models" and buy and sell purely based on what comes up on the screen. These investors claim that using the screen removes emotions from the investing process. (Those who do not use screens would counter that using a screen mechanically also removes most of the intelligence from the process.) One of the proponents of using screens as a starting point is Eric Ryback, and one of the most famous advocates of screens as a mechanical system is James O'Shaughnessy.
Momentum. Momentum investors look for companies that are not just doing well, but that are flying high enough to get nose bleeds. "Well" is defined as either relative to what investors were expecting or relative to all public companies as a whole. Momentum companies often routinely beat analyst estimates for earnings per share or revenues or have high quarterly and annual earnings and sales growth relative to all other companies, particularly when the rate of this growth is increasing every quarter. This kind of growth is viewed as a sign that things are really, really good for the company. High relative strength is often a category in momentum screens, as these investors want to buy stocks that have outperformed all other stocks over the past few months.
CANSLIM. CANSLIM is a system pioneered by William J. O'Neil that is a hybrid of quantitative analysis and technical analysis, detailed in his book How to Make Money in Stocks. According to Investor's Business Daily, O'Neil's newspaper, the "C'' and ''A'' of the CANSLIM formula tell investors to look for companies with accelerating Current and Annual earnings. The ''N'' stands for New, as in new products, new markets, or new management. ''S'' stands for Small capitalization and big volume demand. ''L'' tells investors to figure out whether the company is a Leader or Laggard. ''I'' has them look for Institutional sponsorship, and ''M'' concentrates on the direction of the Market. O'Neil originally created Investor's Business Daily to be a tool that investors could use to practice CANSLIM, although it has become a very widely read business publication by all types of investors. CANSLIM also includes components of the next type of analysis - technical analysis.
Arguments Against Quantitative Analysis. Because quantitative analysis hinges on screens that anyone can use, as computing horsepower becomes cheaper and cheaper many of the pricing inefficiencies quantitative analysis finds are wiped out soon after they are discovered. If a particular screen has generated 40% returns per year and becomes widely known, and if lots of money flows into the companies that the screen identifies, the returns will start to suffer.
As "fuzzy" as fundamental analysis might be, there are often times that knowing even a little about the company you are buying can help a lot. For instance, if you are using a high-relative-strength screen, you should always check and see if the companies you find have risen in price because of a merger or an acquisition. If this is the case, then the price will probably stay right where it is, even if the "screen" you used to pick this company has generated high annual returns in the past.
Technical Analysis - Buying the Chart
What would you do if you truly believed that all information about publicly traded companies was efficiently distributed and that nobody could get an edge on anyone else by either understanding the business or analyzing the numbers? You might consider simply giving up on beating the market's returns by buying an index fund. Some investors have taken an alternate route, attempting to create a set of tools that might tell them what other investors thought about a stock at any given time, particularly looking for the footprints of large institutional investors that tend to cause the most extreme price changes. Investors who focus on this kind of psychological information call themselves technical analysts and believe that charts can sometimes provide insight into the psychology surrounding a stock. Although there are plenty of pure chartists, some investors just use charts to time investments after looking at them from a fundamental or quantitative perspective.
There is no set of clearly defined approaches to technical analysis, but there are a number of different tools. The most important indicators seem to be specific chart formations that show certain price movements at times when trading volume is at a certain level. The most common kinds of charts include point and figure charts, logarithmic charts, and Japanese candlesticks, to name a few.
Arguments Against Technical Analysis. Technical analysis assumes that certain chart formations can indicate market psychology about either an individual stock or the market as a whole at key points. However, most of the statistical work done by academics to determine whether the chart patterns are actually predictive has been inconclusive at best, as detailed in Burton Malkiel's A Random Walk Down Wall Street. Much of the faith in technical analysis hinges on anecdotal experience, not any kind of long-term statistical evidence, unlike certain quantitative and fundamental methodologies that have been shown in many instances to be pretty predictive. Critics of technical analysis feel that it is basically as useful as reading tea leaves.
Trading - Doing What Works
As trading commissions have fallen and more and more people have gained access to instantaneous data about stock prices, trading has become more and more popular, and very likely much too popular, somewhat like Madonna or Beanie Babies. Traders normally use a hodgepodge of fundamental, quantitative, and technical techniques with a short-term orientation. Trading tends to be a highly charged experience where one looks to make a few%age points from each trade. Although widespread, trading is far from a systematized, philosophical body of knowledge that is easily explained in a few paragraphs.