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Investing Theories

Investing theories generally fall into two camps. Those that stick to an efficient market hypothesis and those who believe the market can be beaten. Many other theories attempt to explain and influence the market and the actions of investors in the markets. Here we look at 5 common investing theories that predict how the market is going to behave ignoring the financial soundness of individual businesses.

Efficient Market Hypothesis (EMH)

Controversial for several reason, the efficient market hypothesis states that it is impossible for an investor to use any particular strategy to consistently ‘beat the market’ over time. EMH states that with some luck, outperforming the market once in a while can happen, but not without exposure to greater risk.

The EMH hypothesis states that stock is accurately valued until a future event changes that valuation. Therefore, undervalued stocks to not exist, meaning that predicting market trends by gauging the intrinsic value of a stock from its qualitative and quantitative factors is unnecessary.

The main controversy with this hypothesis is the stock market collapse in 2008. EMH would say the stocks of companies that dropped 20 percent or more in a single day were an accurate representation of the value of those companies. An adherent to EMH would be wise to own a wide range of stocks to profit from the general rise of the market. Investors like Warren Buffett have consistently beaten the market by finding irrational prices within the overall market, a strategy that goes against the theories of EMH.

Fifty Percent Principle

This investing strategy is based on changes in the market rather than on buying and selling stocks based on a company’s underlying value. The fifty percent theories predict that an observed trend will undergo a price correction of one-half to two-thirds of the change in price. This means that if, as an extreme example, a stock has been on an upward trend and gained 20 percent, it will fall back 10 percent before continuing its rise.

This correction is thought to be a natural part of the trend, usually caused by nervous investors taking profits early to avoid getting caught in a true reversal of the trend later on. If the correction exceeds 50 percent of the change in price, it is considered a sign that the trend has failed and the reversal has come prematurely. The drop in price is looked upon as a natural occurrence, when it could just be investors cashing in on their gains.

Greater Fool Theory

The greater fool hypothesis proposes that investors can profit from investing as long as there is a greater fool than yourself to buy the investment at a higher price. This means that you could make money from an overpriced stock as long as someone else is willing to pay more to buy it from you. The potential buyer is considered the greater fool because they would be buying an overvalued investment based on the same lack of knowledge as the original buyer.

This investment strategy ignores data and is based on a gamble that there will always be someone willing to pay a higher price for a stock. After a market correction the investor could lose out if the probability of gain is not assessed correctly. The controversy stems from the fact that investing based on a lack of information is a riskier proposition than over-analysing data.

Odd Lot Theory

Odd lots are small blocks of stocks held by individual investors. Selling out of odd lots, according to this theory, are seen as an indicator of when to buy into a stock. Unlike the efficient market hypothesis, which says the collective knowledge of investors is always right, the odd lot theories states that the collective wisdom of small investors is almost always wrong. This is not always an accurate hypothesis, individual investors are more mobile than big institutional funds and can react to severe news faster, so odd lot sales can actually be a precursor to a wider sell-off in a failing stock instead of just a mistake on the part of small investors.

How successful an investor or trader following the theory is, depends heavily on whether he checks the fundamentals of companies that the theory points toward or simply buys blindly.

Loss Aversion Theory (Prospect Theory)

Prospect theory states that people’s perceptions of gain and loss are skewed. These theories are more about investing behaviour than investing strategy. The hypothesis states that most investors will prefer an investment that has a perception of potentially smaller gains if it means a reduced risk of loss.
For the investor, overcoming the emotional reflex of placing overweighted importance on negative prospects, will enable them to use dispassionate intellectual analysis to make brave decisions regarding their strategy, to get the returns they want.