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When I first started studying investing the literature I was reading pointed me towards something called technical analysis. As I started asking questions about this trying to determine exactly what this meant, I started to discover that technical analysis is actually a somewhat controversial investment strategy. So, my question is what strategies are out there, what defines them, and why would anyone choose one over another?

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There are two umbrellas in investing: active management and passive management.

Passive management is based on the idea "you can't beat the market." Passive investors believe in the efficient markets hypothesis: "the market interprets all information about an asset, so price is equal to underlying value".

Another idea in this field is that there's a minimum risk associated with any given return. You can't increase your expected return without assuming more risk. To see it graphically:

Markowitz efficiency frontier

As expected return goes up, so does risk. If we stat with a portfolio of 100 bonds, then remove 30 bonds and add 30 stocks, we'll have a portfolio that's 70% bonds/30% stocks. Turns out that this makes expected return increase and lower risk because of diversification.

Markowitz showed that you could reduce the overall portfolio risk by adding a riskier, but uncorrelated, asset! Basically, if your entire portfolio is US stocks, then you'll lose money whenever US stocks fall. But, if you have half US stocks, quarter US bonds, and quarter European stocks, then even if the US market tanks, half your portfolio will be unaffected (theoretically). Adding different types of uncorrelated assets can reduce risk and increase returns.

Let's tie this all together. We should get a variety of stocks to reduce our risk, and we can't beat the market by security selection. Ideally, we ought to buy nearly every stock in the market so that So what's our solution? Why, the exchange traded fund (ETF) of course!

An ETF is basically a bunch of stocks that trade as a single ticker symbol. For example, consider the SPDR S&P 500 (SPY). You can purchase a unit of "SPY" and it will move up/down proportional to the S&P 500. This gives us diversification among stocks, to prevent any significant downside while limiting our upside.

How do we diversify across asset classes? Luckily, we can purchase ETF's for almost anything: Gold ETF's (commodities), US bond ETF's (domestic bonds), International stock ETFs, Intl. bonds ETFs, etc. So, we can buy ETF's to give us exposure to various asset classes, thus diversifying among asset classes and within each asset class. Determining what % of our portfolio to put in any given asset class is known as asset allocation and some people say up to 90% of portfolio returns can be determined by asset allocation.

That pretty much sums up passive management. The idea is to buy ETFs across asset classes and just leave them. You can readjust your portfolio holdings periodically, but otherwise there is no rapid trading.

Now the other umbrella is active management. The unifying idea is that you can generate superior returns by stock selection. Active investors reject the idea of efficient markets.

A classic and time proven strategy is value investing. After the collapse of 07/08, bank stocks greatly fell, but all the other stocks fell with them. Some stocks worth $100 were selling for $50. Value investors quickly snapped up these stocks because they had a margin of safety. Even if the stock didn't go back to 100, it could go up to $80 or $90 eventually, and investors profit.

The main ideas in value investing are: have a big margin of safety, look at a company's fundamentals (earnings, book value, etc), and see if it promises adequate return. Coke has tremendous earnings and it's a great company, but it's so large that you're never going to make 20% profits on it annually, because it just can't grow that fast.

Another field of active investing is technical analysis. As opposed to the "fundamental analysis" of value investing, technical analysis involves looking at charts for patterns, and looking at stock history to determine future paths. Things like resistance points and trend lines also play a role. Technical analysts believe that stocks are just ticker symbols and that you can use guidelines to predict where they're headed.

Another type of active investing is day trading. This basically involves buying and selling stocks every hour or every minute or just at a rapid pace. Day traders don't hold onto investments for very long, and are always trying to predict the market in the short term and take advantage of it. Many individual investors are also day traders.

The other question is, how do you choose a strategy? The short answer is: pick whatever works for you. The long answer is:

  1. Day trading and technical analysis is a lot of luck. If there are consistent systems for trading , then people are keeping them secret, because there is no book that you can read and become a consistent trader. High frequency trading (HFT) is an area where people basically mint money, but it s more technology and less actual investing, and would not be categorized as day trading.

  2. Benjamin Graham once said:

    In the short run, the market is a voting machine but in the long run it is a weighing machine.

Value investing will work because there's evidence for it throughout history, but you need a certain temperament for it and most people don't have that. Furthermore, it takes a lot of time to adequately study stocks, and people with day jobs can't devote that kind of time.

  1. So that leaves us with passive management. This is, in my opinion, the best idea for individual investors. That's because most active management firms actually underperform the market (both in the short and long run), and individuals can't dedicate the time necessary to become great investors (most can't).

So there you have it. This is my opinion and by no means definitive, but I hope you have a starting point to continue your study. I included the theory in the beginning because there are too many monkeys on CNBC and the news who just don't understand fundamental economics and finance, and there's no sense in applying a theory until you can understand why it works and when it doesn't.

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If you say technical analysis / day trading is just luck, do you also mean to say that books like this amazon.com/Forex-Patterns-Probabilities-Strategies-Range-Bound/… are scams? –  Pacerier Nov 27 '13 at 8:04
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