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Stock market prediction is the act of trying to determine the future value of a company stock or other financial instrument traded on a financial exchange. The successful prediction of a stock's future price could yield significant profit. The efficient-market hypothesis suggests that stock price movements are governed by the random walk hypothesis and thus are inherently unpredictable. Others disagree and those with this viewpoint possess a myriad of methods and technologies which purportedly allow them to gain future price information.

The random walk hypothesis [edit]

When applied to a particular financial instrument, the random walk hypothesis states that the price of this instrument is governed by a random walk and hence is unpredictable. If the random walk hypothesis is false then there will exist some (potentially non-linear) correlation between the instrument price and some other indicator(s) such as trading volume or the previous day's instrument closing price. If this correlation can be determined then a potential profit can be made.

Prediction methods [edit]

Prediction methodologies fall into three broad categories which can (and often do) overlap. They are fundamental analysis, technical analysis (charting) and technological methods.

Fundamental analysis [edit]

Fundamental Analysts are concerned with the company that underlies the stock itself. They evaluate a company's past performance as well as the credibility of its accounts. Many performance ratios are created that aid the fundamental analyst with assessing the validity of a stock, such as the P/E ratio. Warren Buffett is perhaps the most famous of all Fundamental Analysts.

Fundamental analysis is built on the belief that human society needs capital to make progress and if a company operates well, it should be rewarded with additional capital and result in a surge in stock price. Fundamental analysis is widely used by fund managers as it is the most reasonable, objective and made from publicly available information like financial statement analysis.

Another meaning of fundamental analysis is beyond bottom-up company analysis, it refers to top-down analysis from first analyzing the global economy, followed by country analysis and then sector analysis, and finally the company level analysis.

Technical analysis [edit]

Technical analysts or chartists are not concerned with any of the company's fundamentals. They seek to determine the future price of a stock based solely on the (potential) trends of the past price (a form of time series analysis). Numerous patterns are employed such as the head and shoulders or cup and saucer. Alongside the patterns, statistical techniques are used such as the exponential moving average (EMA). Candle stick patterns are believed to be first developed by Japanese rice merchants, and nowadays widely used by technical analysts.

Alternative methods [edit]

With the advent of the digital computer, stock market prediction has since moved into the technological realm. The most prominent technique involves the use of artificial neural networks (ANNs) and Genetic Algorithms. ANNs can be thought of as mathematical function approximators. The use of ANN simulates how human brain functions, by feeding computers with massive data to mimic human thinking. The most common form of ANN in use for stock market prediction is the feed forward network utilising the backward propagation of errors algorithm to update the network weights. These networks are commonly referred to as Backpropagation networks. Since NNs require training and have a large parameter space, it is useful to modify the network structure for optimal predictive ability.

References [edit]

• Graham, B. The Intelligent Investor HarperCollins; Rev Ed edition, 2003.
• Lo, A.W. and Mackinlay, A.C. A Non-Random Walk Down Wall Street 5th Ed. Princeton University Press, 2002.
• Azoff, E.M. Neural Network Time Series Forecasting of Financial Markets John Wiley and Sons Ltd, 1994.