When picking a portfolio manager an investor should have a clear idea of the different philosophies of managers.
What the individual investor believes about market efficiency may determine if they hire a technical analyst or a fundamental analyst or maybe even go without either and just invest in an index fund.
The technical analyst will use a multitude of moving averages, oscillators, and trend following techniques to try and outperform the market and generate added value to the investor.
This type of portfolio manager believes they can determine the future direction of a stock or index by analyzing the past performance of the stock or index.
The technical analyst does not believe in the random walk theory.
The random walk theory states, ” the past movement or direction of the price of a stock or overall market cannot be used to predict its future movement”.
The fundamental analyst on the other hand looks at the numbers behind the stock’s price.
This type of analyst tries to uncover information gathered from the company’s fundamental data such as its income statement or balance sheet that may enable them to outperform the overall market.
Investopedia describes this as, “A method of evaluating a security that entails attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors”.
Efficient Market Hypothesis
Before choosing fundamental or technical analysis the investor should review the efficient market hypothesis.
There are three forms of market efficiency:
- Weak form – This states that all past prices of a stock are reflected in today’s stock price. Therefore technical analysis cannot be used to beat the market. Weak form advocates believe fundamental analysis can be used to find stocks that are under or overvalued.
- Semi-Strong form – This signifies that all public information is calculated into the price of a stock. Therefore neither fundamental nor technical analysts can beat the market. Advocates of this form believe the only way to beat the market is to utilize information that is not available to the public.
- Strong form – This states that all information both public and private is already accounted for in the stock’s price. This means that even an insider would not be able to outperform the market.
Depending on the investors beliefs about the random walk theory and market efficiency will determine what type of analyst they put in charge of their money.