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Share Investment: Strategy Concept

The price of a share, as for the price of any asset that is sold in a free market, is determined by the demand for and supply of the share. The balance, at any moment, between buyers and sellers of a company’s shares is determined by the market participants’ assessments of the future profitability of the company and the likely future of the share’s price movements. Analysts take one of two approaches in forming a view on the two issues. They may conduct their evaluations, and issue their buy/sell recommendations, on the basis of their examination of the variables that finance and economic theories identify as being relevant to a company’s future. Alternatively they may seek to identify patterns in the historic share price series and draw conclusions about the future price movements on the basis of these patterns. ‘Fundamental analysts’ comprise the former group, and ‘technical analysts’ comprise the latter.

Among those who subscribe to fundamental analysis, two groups can be identified. Group One: Their approach is referred to as the ‘bottom-up’ approach and is drawn from finance theory. The other group looks at prospective developments in the broader economic environment within which various industry groups operate. These analysts are referred to as ‘top-down’ fundamental analysts, and the theoretical frameworks on which they draw generally come from macroeconomics. The variables that are identified as being of relevance to the future performance of various industry groups include developments in the major international economies, changes in exchange rates, changes in interest rates, government policy reactions to the rate of growth and inflation the economy, developments in the balance of payments, and the performance of wages and productivity growth.

Technical analysis adopts an alternative approach to share price forecasting. The approach is based on the assumption that, over time, apparent trends and patterns in price movements are formed. It is further assumed that as a new pattern emerges, the behaviour experienced in the historic pattern will also re-emerge. Two of the principal models used by technical analysts are moving average models and charting.

One of the modern theories on the determination of changes in share value is the ‘random walk’ hypothesis. This hypothesis contends that share price observations are independent of each other and that the next price movement cannot be directionally predicted. The ‘efficient markets’ hypothesis is formalisation of the random walk hypothesis. It challenges the view that analysts are able to select a portfolio of shares, which will outperform the overall market. The challenge rests upon the view that markets are informationally efficient and therefore all relevant information is already reflected in the current price of a share. Three forms and tests of market efficiency are identified: weak, semi-strong and strong from market efficiency. The majority of empirical studies find in favour of the first two forms of efficiency; however, there is less agreement on the strong form of efficiency.