Beliefs and market positions
Agents, in trading securities, bet on change in market’s evaluation of securities. Thus, the market price of securities is adjusted continually.
If agents believe that a security will increase in value, they are said to act from a bullish/ long position. If the reverse is true, they are said to act from a bearish/ short position.
Agents may also believe a certain company will outperform or underperform other companies in the sector.
Jitters
It is natural that the market tries to converge on the value of a security only gradually, as they process information about it through trades and bets. Thus, there are short term jitters in the stock price curve, which are different from the long-term booms and busts. Jitters result either from temporary change in sentiment of the traders while assimilating new information, or it can be the result of a large trade increasing the supply of certain securities relative to the demand.
Long-term booms and busts also a natural consequence of the heuristic nature of matching demand and supply.
Human instincts and biases
The market, being composed of humans, benefits and suffers from strengths and weaknesses of human instincts. Behavioral economics models can be used to explain the quirks of market evaluation.
Risk aversion
Humans are subject to risk aversion: they are more averse to loosing than they yearn for profits. This explains why security prices are fast to drop, but slow to rise: investors, eager to stop loss are more eager to sell, and they are more cautious in buying in the future.
Recency bias
Recent news about a security tends to affect evaluation more severely than it perhaps should. Ideally, long-term information about the asset should be a very important part of the evaluation.
Comparative measures
P/E ratio
P/E or price/ earning ratio measures the size of a security’s price relative to the associated dividend. This is often used to identify high dividend yield stocks, which constitute attractive investments. One can think of the units as being years it takes to earn enough dividend to equal the price.
Comparison can even be between the states of a derivative at different points in time: Considering the P/E curve and the stock price together can be useful.
Price / book value (P/B) ratio
Here one considers the total asset value (aka book value) of a company and sees if the price is reasonable compared to it.
Risks
Securities which constitute riskier investments have lower value compared to less risky securities yielding similar returns. Judging investment risks is described elsewhere.
Security analysis
Security analysts gather information, including non-public information, to advice people on trading strategies to maximize their profit. They run a special risk of being charged with insider trading.
Analyst reports and news articles are sometimes available for free on the internet.
Mutual fund Ratings
Mutual funds are rated by agencies which examine their past performance and holdings: Eg Morningstar.
Returns
Dividend yield vs growth
There are two avenues for profiting from an investment: a share in profits earned, increase in value of the share in the business - which may be turned into a profit by selling it to someone else.
Value stocks which have shown high dividend (distributed profit) yield relative to capitalization are attractive. Growth stocks, even if they have low dividend yield, have a potential to grow in value in the future - it is possible that undistributed profits have been invested to such fuel growth. ’Balanced businesses’ lie between these two extremes.
Total returns
Total returns adds (dividend/ interest) income and capital/ value appreciation.
One can judge the potential for returns by observing the total returns over a period of time trailing from the current date (week/ trimester/ year).