Learning Objectives
After studying this chapter, you should know about:
- Investing activity and various approaches to investing
- Overview of Technical Analysis for investing in stocks
- Overview of Fundamental Analysis for investing in stocks
- Overview of Quantitative Analysis (Econometrics approach)
- Behavioral Finance approach to equity investing
- Regulatory framework governing research activities
- Practical application of research methodologies
📑 Chapter Navigation
Investment Fundamentals
📖 Complete Course Navigation
Foundation (Ch 1-4)
- Ch 1: Research Analyst Profession
- Ch 2: Securities Market
- Ch 3: Terminology
- Ch 4: Research Fundamentals
Analysis (Ch 5-8)
Advanced (Ch 9-13)
Annexures (Ch 14-16)
4.1 What is Investing?
Investment, in the context of securities market, involves upfront commitment of a sum of money to earn returns on it over a period of time. It involves thorough analysis of the underlying security in terms of safety/risk, income and growth potential.
Detailed Differentiation: Trading vs. Speculation vs. Investing
| Aspect | Trading | Speculation | Investing |
|---|---|---|---|
| Primary Objective | Earn spread between buying and selling price | Bet on short-term price movements | Benefit from increase in asset's intrinsic value |
| Time Horizon | Very short-term (intraday to weeks) | Short-term (days to months) | Long-term (months to years) |
| Risk Approach | Technical risk management | High-risk, high-reward bets | Calculated risk based on fundamentals |
| Analysis Method | Technical patterns, momentum | Market sentiment, news events | Comprehensive fundamental analysis |
| Decision Basis | Price movements without regard to underlying value | Market psychology and short-term catalysts | Intrinsic value assessment and growth potential |
| Capital Requirement | Often uses leverage | Often uses leveraged funds | Own capital commitment |
Investment Activity Focus: Investment focuses on the potential of an asset's value to increase over a period. In the securities market context, value increases when:
- The asset generates higher cash flow without proportionate increase in risk
- The risk associated with the asset decreases without proportionate decrease in cash flow
4.1.1 Active Investing
Definition and Characteristics
Active investing involves identifying specific securities or sets of securities that should be purchased or sold based on detailed analysis.
Key Features of Active Investing:
- Constant Portfolio Evaluation: Every security in the investment portfolio requires ongoing assessment
- Value-Based Decision Making: Sell securities priced above fair value, buy those below fair value
- Higher Transaction Frequency: More effort and greater number of transactions compared to passive strategies
- Performance Objective: Earn returns above the broader asset class (alpha generation)
- Research Intensive: Requires deep fundamental and technical analysis
4.1.2 Passive Investing
Definition and Approach
Passive investing involves investing in a broad set of securities that fairly represent the asset class, typically following indexing strategies.
Characteristics of Passive Investing:
- Index Tracking: Buys all securities in a chosen index (e.g., Nifty 50, Sensex)
- Broad Asset Class Focus: Analysis limited to broader asset class rather than individual securities
- Lower Transaction Costs: Fewer transactions, reduced management fees
- Performance Objective: Match the returns of the selected asset class (beta capture)
- Diversification Benefit: Automatic diversification across index constituents
4.2 The Role of Research in Investment Activity
The role of a fundamental research analyst comprises two distinct but interconnected parts:
- Research: Obtaining all necessary information
- Analysis: Analyzing available information to arrive at actionable conclusions
Detailed Research Process and Methodology
Primary Research Activities:
4.2.1 Insider Information vs. Mosaic Analysis
SEBI Regulatory Framework
Research work must never involve collating insider information. Understanding the distinction between insider information and mosaic analysis is crucial for compliance with SEBI regulations.
Insider Information - SEBI Definition
Material non-public information that, when published, would immediately affect an investor's decision to buy or sell the security.
Three Key Criteria:
- Source Reliability: How credible and authoritative is the information source
- Material Impact: Would the information significantly influence investment decisions
- Information Certainty: How definitive and confirmed is the information
Examples: Insider Information vs. Acceptable Information
| Scenario | Classification | Reasoning |
|---|---|---|
| CEO discussing unpublished acquisition proposal | Insider Information | Material, non-public, from authoritative source |
| Employee mentioning increased workload in purchase department | Acceptable for Mosaic | Indicates business activity but not material price-sensitive info |
| Supplier noting increased order volumes | Acceptable for Mosaic | Public domain information that can be aggregated |
| CFO revealing unannounced earnings revision | Insider Information | Directly price-sensitive, material, non-public |
Mosaic Analysis - SEBI Accepted Practice
Collating information from different sources, which individually may not be significant but when combined with other public or non-public information provides critical insights. This analytical approach is acceptable and encouraged.
Mosaic Analysis Example:
Combining: (1) Employee workload increase + (2) Supplier order volume growth + (3) Increased job postings + (4) Public quarterly guidance = Conclusion of business expansion without using any single piece of insider information.
4.3 Technical Analysis
Core Assumption: All information that can affect share performance - including company fundamentals, economic factors, and market sentiments - is already reflected in stock prices.
Three Pillars of Technical Analysis
The Three Essential Elements:
| Pillar | Description | Practical Application |
|---|---|---|
| 1. Price History | Past prices provide indications of underlying trend and direction | Chart patterns, trend lines, support/resistance identification |
| 2. Volume Analysis | Trading volume provides inputs on underlying strength of trend | Volume confirmation of breakouts, trend strength validation |
| 3. Time Dimension | Time span factors in impact of long-term influences on prices | Multiple timeframe analysis, seasonal patterns |
Key Technical Analysis Concepts and Practical Principles
Core Concepts:
- Trends: Upward, downward, or sideways price movements with specific characteristics
- Support Levels: Price points where significant buying interest emerges
- Resistance Levels: Price points where significant selling interest emerges
- Volume Confirmation: Strong volumes should accompany genuine trend movements
- Moving Averages: Smooth out day-to-day fluctuations to identify underlying trends
Practical Trading Application
Support/Resistance Strategy: If a stock price approaches an established resistance level, holders can book profits expecting price retraction. If support/resistance is broken with strong volumes, it indicates trend acceleration and changed supply-demand dynamics.
Chart Types and Pattern Recognition:
- Line Charts: Simple price connectivity showing trend direction
- Bar Charts: Open, high, low, close (OHLC) information
- Candlestick Charts: Japanese technique showing price psychology and reversal patterns
- Best for: Short-term investors and traders - business fundamentals rarely change drastically in short periods
- Limited for: Long-term investing - business fundamentals can change significantly over time, making historical price trends unreliable
4.4 Fundamental Analysis
Core Premise: Since equity shares represent part ownership of a company, long-term value should be driven by returns generated by the company on its share capital.
The Fundamental Analysis Investment Process
Comprehensive Analysis Framework: Three Baskets Approach
1. Economic Analysis
| Analysis Area | Key Questions | Factors to Consider |
|---|---|---|
| Macro-Economic Trends | How are cyclical and secular trends affecting the industry? | GDP growth, inflation, interest rates, currency movements |
| Government Policy | Will regulatory changes help or hinder industry growth? | Tax policies, trade regulations, sector-specific reforms |
| Economic Cycles | Is the economy in expansion, peak, contraction, or recovery? | Business cycle positioning, leading indicators |
2. Industry Analysis
| Analysis Area | Key Questions | Assessment Tools |
|---|---|---|
| Competition Intensity | How intense is competition and is it conducive for existing players? | Porter's Five Forces, market concentration ratios |
| Industry Life Cycle | Is the industry in growth, maturity, or decline phase? | Growth rates, market saturation, innovation cycles |
| Regulatory Environment | How do industry-specific regulations impact profitability? | Compliance costs, barriers to entry, pricing freedom |
3. Company Analysis
| Analysis Area | Key Questions | Evaluation Metrics |
|---|---|---|
| Competitive Positioning | How is the company positioned vs competitors? | Market share, brand strength, competitive advantages |
| Cost Structure | How will costs impact profitability under different scenarios? | Fixed vs variable costs, operating leverage, efficiency ratios |
| Financial Strength | Can the company fund growth and withstand crises? | Debt ratios, cash flows, liquidity ratios, interest coverage |
| Management Capability | Can management execute strategies and handle adversities? | Track record, strategic vision, execution capabilities |
| Governance | Are governance structures aligned with shareholder interests? | Board independence, transparency, shareholder rights |
Detailed Research Questions for Each Analysis Level
Economic Analysis Questions:
- What are the current and expected GDP growth trends?
- How are interest rate changes affecting the sector?
- What is the impact of currency fluctuations on the business?
- How do government policies affect industry prospects?
- What are the implications of global economic trends?
Industry Analysis Questions:
- What is the current stage of the industry life cycle?
- How fragmented or concentrated is the industry?
- What are the barriers to entry and threat of substitutes?
- How is technology disrupting traditional business models?
- What are the key success factors in this industry?
Company Analysis Questions:
- What are the company's sustainable competitive advantages?
- How has management performed during previous challenging periods?
- What is the quality and predictability of earnings?
- How efficient is capital allocation and return on invested capital?
- What are the key risks facing the business model?
4.5 Quantitative Research and Econometric Analysis
Quantitative approach uses econometric analysis and mathematical models to analyze both technical and fundamental factors, moving beyond subjective interpretation to data-driven insights.
Quantitative Applications in Technical Analysis
- Statistical Relationships: Studying correlations between price up/down moves and volume
- Pattern Recognition: Using algorithms to identify chart patterns and trend reversals
- Momentum Indicators: Mathematical formulations of price momentum and mean reversion
- Volatility Analysis: Statistical measures of price volatility and trading ranges
Quantitative Applications in Fundamental Analysis
- Financial Metrics Analysis: Identifying leading indicators for company performance
- Time Series Analysis: Extrapolating future earnings from historical data patterns
- Regression Analysis: Understanding relationships between financial variables
- Econometric Models: Sophisticated approaches to refine fundamental analysis output
Major Limitations of Pure Quantitative Approach in Fundamental Analysis
- Data Availability Issues: Limited availability of comparable historical information
- Accounting Standards Changes: Frequent changes make historical data less comparable
- Business Model Evolution: Changes in business models reduce relevance of past data
- Market Condition Changes: Past data may not reflect current market conditions
- Structural Breaks: Economic and regulatory changes create discontinuities in data relationships
4.6 Behavioral Approach to Equity Investing
Investment decisions should be based on rational analysis of available information. However, they are often influenced by behavioral biases that lead to suboptimal choices and market inefficiencies.
Core Behavioral Finance Philosophy
"Securities prices deviate from their fair values (both upside and downside) because of the fear and greed of market participants, creating profit opportunities for disciplined investors."
Common Behavioral Biases in Investment Decision-Making
| Bias Type | Description | Market Impact | Example |
|---|---|---|---|
| Loss Aversion | Pain of losing is stronger than pleasure of gaining | Holding losers too long, selling winners too early | Refusing to sell a stock at 20% loss hoping for recovery |
| Confirmation Bias | Seeking information that confirms existing beliefs | Ignoring negative news about owned stocks | Only reading bullish reports about portfolio holdings |
| Herding Behavior | Following crowd decisions rather than independent analysis | Creates bubbles and market crashes | Buying during market euphoria, selling during panic |
| Anchoring Bias | Over-relying on first piece of information received | Incorrect valuation based on purchase price | Considering ₹1000 stock "cheap" at ₹800 without analysis |
| Overconfidence Bias | Overestimating one's ability to predict outcomes | Excessive trading, inadequate diversification | Making frequent trades believing in superior market timing |
| Recency Bias | Giving more weight to recent events | Extrapolating short-term trends indefinitely | Assuming tech stocks will keep rising after recent gains |
Market Psychology and Price Distortions
Fear-Driven Scenarios:
- Market Panic: Selling quality stocks at deeply discounted prices
- Risk Aversion: Avoiding good investments due to unfounded fears
- Liquidity Preference: Holding cash during optimal investment periods
Greed-Driven Scenarios:
- Bubble Formation: Paying excessive prices for trendy investments
- FOMO (Fear of Missing Out): Chasing past performance
- Leverage Abuse: Taking excessive risks for higher returns
Sample Questions with Detailed Explanations
Question 1
Speculation is _____________ calls made with leveraged funds, unlike investing money which is a _________ disciplined activity for creating wealth.
- Short Term; Long term ✓
- Long term; medium term
- Long term; Short term
- Long term; Long term
Answer: a) Short Term; Long term
Explanation: Speculation involves short-term bets with leveraged funds based on market movements, while investing is a long-term disciplined approach focused on wealth creation through fundamental value growth.
Question 2
Fundamental analysis includes which of the following?
- Economic Analysis
- Industry Analysis
- Company Analysis
- All of the Above ✓
Answer: d) All of the Above
Explanation: Fundamental analysis encompasses the three-basket approach: Economic analysis (macro factors), Industry analysis (sector dynamics), and Company analysis (specific business evaluation).
Question 3
The time span over which price and volume are observed factors in the impact of long term factors that influence prices over a period of time. State whether True or False.
- True ✓
- False
Answer: a) True
Explanation: Time dimension is one of the three essential elements in technical analysis, helping factor in long-term influences on price movements alongside price history and volume analysis.
Question 4
In technical analysis, impact of day to day fluctuations in prices is annulled by which of the following factors?
- Increasing Time Period of price charts
- Using liquidity parameter along with prices
- Using Moving Averages ✓
- None of the above
Answer: c) Using Moving Averages
Explanation: Moving averages smooth out day-to-day price fluctuations by averaging prices over a specific period, making it easier to identify underlying trends without noise from daily volatility.
Question 5
Which of the following statement about limitation of quantitative approach to fundamental analysis is correct?
- Quantitative approach cannot be used to analyse economy
- Changes in accounting standards, business structures and regulations limit the effectiveness of quantitative analysis in forecasting future ✓
- Investing is an intuitive art with very limited scope for quantitative analysis
- None of the above
Answer: b) Changes in accounting standards, business structures and regulations limit the effectiveness of quantitative analysis in forecasting future
Explanation: The primary limitation of pure quantitative approaches is that frequent changes in accounting standards, business models, and regulatory environment make historical data less comparable and reliable for future predictions.
Key Takeaways for NISM Exam Preparation
- Investment vs. Trading: Understand time horizons, risk approaches, and decision methodologies
- Active vs. Passive: Know the differences in approach, costs, and performance objectives
- Research Process: Distinguish between research (information gathering) and analysis (interpretation)
- Regulatory Compliance: Understand SEBI guidelines on insider information vs. mosaic analysis
- Analysis Approaches: Technical for short-term, fundamental for long-term investing
- Three-Basket Framework: Economic, industry, and company analysis in fundamental research
- Quantitative Limitations: Data availability and comparability issues in econometric approaches
- Behavioral Finance: Impact of fear, greed, and cognitive biases on market pricing and investment decisions
Note: This comprehensive chapter covers all key concepts from the NISM Research Analyst Certification Examination syllabus. For exam success, focus on understanding the practical applications of each concept and their regulatory implications.
Continue Your Learning Journey
You've completed Chapter 4! Here's what comes next:
- Chapter 5: Economic Analysis - Understand macro and microeconomic factors affecting investments
- Chapter 6: Industry Analysis - Learn sector-specific analysis techniques
- Chapter 7: Company Analysis - Business - Evaluate business models and competitive positioning
- Chapter 8: Company Analysis - Financial - Master financial statement analysis
