where other factors are so-called “state variables” that describe the overall macroeconomy.
Advantage – very general model that includes economic conditions that surely affect stock market returns.
Disadvantage – not clear which factors to use exactly.
Stock Valuation Models
Behavorial school – they argue that financial markets are not always efficient. That is, at times prices do not reflect all available information accurately and rapidly.
Information uncertainty causes slow market responses to information that leads to price continuation
Irrational investors cause prices to move in ways not expected by rational investors.
Stock Price Time Arrival of good news to the market Slow market response, or price continuation
Technical analysis – examine charts of stock prices to find trends in them over time. Buy and sell stocks based on trends. (Problem: Stock prices are a random walk according to weak form tests of market efficiency.)
Fundamental analysis – examine the accounting statements, financial position, and industry and economic conditions to buy and sell stocks. (Problem: Stock prices cannot be predicted based on available public information according to semi-strong tests of market efficiency.)
Diversification – reduce risk by spreading investments in financial instruments that are not perfectly correlated with one another.
Dollar-cost averaging – invest regularly in the stock market so that you buy at some average price and earn the long-run average rate of return on stocks.
Portfolio rebalancing – fix some target percentages for your diversified portfolio (e.g., 60% stocks and 40% bonds) and once a year buy and sell to realign this percentages. In this way you sell assets that increase in value and buy assets that have decreased in value.