Key Takeaways
- Investment analysis is the process of evaluating a security, a sector, or the stock market as a whole.
- Fundamental analysis involves evaluating the strength of a company’s business, while technical analysis uses statistical patterns to identify opportunities.
- A top-down strategy uses macroeconomic factors to construct a portfolio, while a bottom-up strategy builds a portfolio by evaluating individual companies.
- There is no requirement to analyze a stock or fund to be a successful investor. There are plenty of professionally managed funds to help you reach your goals.
Definition and Examples of Investment Analysis
Investment analysis is a catch-all term for a set of techniques you can use to gauge how an investment will perform and whether it’s suitable for your goals and risk tolerance. You can use investment analysis to evaluate an individual asset, like a stock or bond, or apply the same principles to determine your outlook for a particular market sector. You could even analyze the overall stock market.
Fidelity’s quarterly sector update from the end of 2021 gives you a general example of how investment analysis works. The report estimated that the financials, materials, and health care sectors would outperform the stock market. It also associated this performance with relatively cheap valuations and a continued economic recovery. However, due to several factors such as high valuations and possible interest rate hikes, Fidelity projected that the real estate and utilities sectors would not perform as well as they have in the past.
How Investment Analysis Works
There are several different approaches to investment analysis. Here are some of the most common methods.
Fundamental vs. Technical Analysis
Fundamental and technical analysis are two approaches you can use to evaluate individual stocks. The right approach depends on your style as an investor.
If you take a long-term approach to investing, you might prefer to use fundamental analysis. This method uses the strength of a company’s underlying business and macroeconomic factors to identify opportunities. Fundamental analysis uses metrics like earnings per share, price-to-earnings ratio, and dividend yield to identify stocks with strong growth potential or those that the market has undervalued.
Short-term investors and day traders may rely on technical analysis, which uses patterns on charts that reflect changes in stock prices or trading volume.
Note
At the core of technical analysis is the idea that all publicly available information is already priced into a stock, so you don’t need to analyze the fundamentals of the business.
Top-Down vs. Bottom-Up Analysis
Two types of investment analysis used in portfolio construction are top-down and bottom-up analysis. A top-down strategy considers broader economic factors to build a portfolio, while a bottom-up strategy focuses on the financial performance of individual companies and securities.
A top-down strategy builds a portfolio based on macroeconomic indicators, market trends, and global economic news. Your investment selections are determined by how you believe the overall stock market and the economy will perform. Many top-down investors favor mutual funds and exchange-traded funds (ETFs) that invest in a broad mix of stocks. Individual stocks and bonds play a secondary role.
Bottom-up analysis uses metrics specific to individual companies to build a portfolio. A bottom-up approach may consider financial performance measurements like profit margin, earnings per share, price-to-earnings ratio, and the price-to-sales ratio.
Security Analysis vs. Portfolio Analysis
Security analysis involves analyzing the strength of an individual investment. Portfolio analysis consists of evaluating all your holdings to determine each investment's role and whether the level of risk exposure is appropriate.
Security analysis is fundamental to value investing, a style pioneered by the late Benjamin Graham—Warren Buffett’s mentor—and David Dodd. Graham and Dodd believed that you should determine a security’s intrinsic value and buy assets that appear undervalued. Additionally, they thought it best to avoid predicting movements in a stock’s price altogether.
Note
Graham and Dodd believed you should hold a minimum of 40 stocks at any one time to provide sufficient diversification.
Portfolio analysis evaluates the investments a portfolio holds. For example, you might use it to assess a mutual fund’s performance against a benchmark index or determine if the funds are appropriately diversified. In addition, it may include stress testing that shows how a portfolio would hold up against adverse events.
What It Means for Individual Investors
Your approach to investment analysis will differ based on your goals and risk tolerance. For example, if you’re a buy-and-hold investor, fundamental analysis might work better for you; if you’re hoping to earn a quick profit, you may prefer technical analysis.
But it’s important to note that you don’t have to engage in extensive investment analysis to be successful. There are plenty of set-it-and-forget-it investments that don’t involve scrutinizing financial statements.
Note
As part of portfolio analysis, you’ll want to evaluate your asset allocation, which is the percentage of your assets invested in stocks, bonds, and cash equivalents. A common strategy is to invest aggressively when you have a long time horizon by investing primarily in stocks; then, you shift money over time to safer investments, like bonds and cash equivalents.
You could get a sufficiently diversified investment portfolio by choosing a target-date fund—a popular 401(k) investment that automatically rebalance over time. Or you could capitalize on the stock market's growth as a whole by investing in an index fund, such as one that mirrors the . You’ll automatically invest in around 500 of the largest U.S.-based publicly traded companies.
