When it comes to investment, there is no shortage of theories about what makes the market volatile or what a particular market trend means. The two biggest factions on Wall Street have theoretical differences between the supporters of the efficient market theory and those who believe that the market can be defeated. Although this is a fundamental split, many other theories try to explain and influence the market and the behavior of investors in the market.
- Financial markets have been described by formal economic models, which come from several theoretical frameworks,
- The most common model, the efficient market hypothesis, is still controversial because reality does not always conform to theoretical assumptions.
- Other theories do not rely on rational actors or market efficiency, but on human psychology and emotions.
1. Efficient market hypothesis
The Efficient Market Hypothesis (EMH) is still a topic of debate. EMH points out that the market price of a stock contains all known information about the stock. This means that the valuation of the stock is accurate before future events change the valuation. Because the future is uncertain, EMH believers who hold a large number of stocks and profit from the general rise in the market are much better. You either believe it and stick to a passive, broad market investment strategy, or you hate it and focus on picking stocks based on growth potential, undervalued assets, etc.
Opponents of EMH point out that Warren Buffett and other investors have consistently beaten the market by finding unreasonable prices throughout the market.
2. The Fifty Percent Rule
The 50% principle predicts (before continuing) that the observed trend will undergo a price correction of one-half to two-thirds of the price change. This means that if a stock has been on an uptrend and has risen by 20%, it will fall back by 10% before continuing to rise. This is an extreme example, because most of the time this rule applies to short-term trends in the buying and selling of technical analysts and traders.
This correction is considered a natural part of the trend, because it is usually caused by the timid investor taking profits as early as possible to avoid falling into a true trend reversal in the future. If the correction exceeds 50% of the price change, it is considered a sign that the trend has failed and the reversal has come early.
3. The Great Fool Theory
The Big Fool Theory proposes that as long as someone who is stupid than you buys an investment at a higher price, you can profit from the investment. This means you can make money from overpriced stocks, as long as others are willing to pay more to buy from you.
Eventually, as any investment market overheats, you run out of fools. Investing according to the Big Fool Theory means ignoring valuations, earnings reports, and all other data. Ignoring the data is as risky as paying too much attention to the data, so after the market adjusts, people may stick to the short end of the big fool theory.
4. Odd Number Theory
Odd stock theory uses the sale of odd stocks—small blocks of stocks held by individual investors—as an indicator of when to buy stocks. When small investors sell, investors who follow the odd share theory buy. The main assumption is that small investors are usually wrong.
The odd lot theory is a reverse strategy based on a very simple form of technical analysis-measuring odd lot sales. The success of an investor or trader who follows the theory depends to a large extent on whether he has checked the fundamentals of the company that the theory points to, or just bought blindly.
Small investors are not always right or wrong, so it is important to distinguish between odd lot sales with low risk tolerance and odd lot sales caused by larger problems. Individual investors are more liquid than large funds and can therefore react to serious news faster, so odd-stock sales may actually be a precursor to a broader sell-off of failed stocks, not just the mistakes of small investors.
5. Prospect Theory
Prospect theory can also be called loss aversion theory. Prospect theory points out that people’s views on gains and losses are biased. In other words, people are more afraid of loss than encouragement. If people are allowed to choose between two different prospects, they will choose the one they think is less likely to end in failure, rather than the one with the greatest benefit.
For example, if you provide someone with two investments, one with a return rate of 5% per year, the other with a return rate of 12%, a loss of 2.5%, and a return rate of 6% for the same year, then that person will choose 5% Investment because he puts unreasonable importance on a single loss, while ignoring a larger gain. In the example above, both options produce a net total return after three years.
Prospect theory is important to financial professionals and investors. Although the risk/return balance clearly illustrates the amount of risk that investors must take to achieve the expected return, prospect theory tells us that few people emotionally understand their intellectual understanding.
For financial professionals, the challenge is to adapt the investment portfolio to the client’s risk profile, not to reward desires. For investors, the challenge is to overcome the disappointing predictions of prospect theory and bravely obtain the desired returns.
6. Rational Expectation Theory
The theory of rational expectations states that participants in the economy will act in ways that are logically predictable. In other words, a person will invest, spend, etc. based on what they rationally think will happen in the future. By doing this, that person creates a self-fulfilling prophecy that helps to realize future events.
Although this theory has become quite important to economics, its usefulness is questionable. For example, investors believe that a stock will rise, and by buying it, this behavior will actually cause the stock to rise. The same transaction can be constructed outside of the theory of rational expectations. An investor notices that a stock is undervalued, buys it, and then watches other investors notice the same thing, thereby pushing the price to its proper market value. This highlights the main problem with the theory of rational expectations: it can be changed to explain everything, but it tells us nothing.
7. Short interest theory
The theory of short interest assumes that high short interest is a harbinger of rising stock prices, which seems unfounded at first glance. Common sense suggests that a stock with high short interest—that is, a stock that many investors are selling short—should be corrected.
The reason is that all these traders, thousands of professionals and individuals carefully check every piece of market data, and they certainly can’t be wrong. They may be right to a certain extent, but in reality the stock price may rise due to a large amount of short selling. Short sellers must eventually make up for their positions by buying the stocks they have shorted. Therefore, buying pressure caused by short positions will push up stock prices.
We have covered a wide range of theories, from technical trading theories such as short interest and fractional theories to economic theories such as rational expectations and prospects. Each theory attempts to impose some type of consistency or framework on millions of buying and selling decisions that make the market rise and fall every day.
Although it is useful to understand these theories, it is also important to remember that there is no unified theory that can explain the financial world. In some periods, a theory seemed to dominate, but it was quickly overthrown. In the financial world, change is the only real constant.