Investing is a complex realm, filled with various theories aiming to decode the mysteries of financial markets and investor behavior.
Before we dive into these theories, it’s essential to understand that financial markets are the subject of rigorous economic models drawing from multiple theoretical frameworks.
While one theory might dominate the discussions, it’s important to remember that reality doesn’t always neatly fit into theoretical molds.
Moreover, some theories shift the focus away from rational actors and market efficiency, instead delving into the fascinating realm of human psychology and emotion.
Now, let’s delve into these controversial investing theories:
What you'll learn:
1️⃣ Efficient Markets Hypothesis (EMH)
The Efficient Markets Hypothesis (EMH) remains a topic of contention in the world of investing. According to EMH, a stock’s market price already includes all known information about that stock.
In simpler terms, it means a stock is accurately valued based on what we currently know, unless something unexpected happens in the future.
Due to the uncertain nature of the future, EMH proponents believe in owning a diverse portfolio of stocks and benefiting from the overall market’s growth. They prefer passive, broad-market investing strategies.
On the flip side, opponents of EMH, like Warren Buffett, argue that they can outperform the market by identifying undervalued assets or stocks with high growth potential, challenging the idea that all stocks are always correctly priced.
☞ Learn More: Is the Stock Market Rigged? (Many Believe So)
2️⃣ Fifty-Percent Principle
The Fifty-Percent Principle deals with the behavior of stock trends. It suggests that when we observe a trend, such as a stock’s price going up, it’s likely to experience a correction of around 50% of the price change before continuing in the same direction.
For instance, if a stock has been on an upward trend and gained 20%, it might drop by 10% before resuming its ascent. This principle is often applied to short-term trends that technical analysts and traders focus on.
The correction is seen as a natural part of the trend, often triggered by nervous investors taking profits early to avoid being caught in a full reversal of the trend later on. If the correction exceeds 50% of the price change, it’s considered a sign that the trend may have failed, and a premature reversal might be in play.
3️⃣ Greater Fool Theory
The Greater Fool Theory suggests that you can make a profit by investing, as long as there’s someone willing to pay a higher price later – the “greater fool.” In essence, you buy an overpriced asset with the expectation that you’ll find someone even more willing to pay a premium for it in the future.
However, this approach has its limits. When too many people chase overpriced assets, the market can overheat, and eventually, there are no more “greater fools” left. Investing solely based on this theory means ignoring important factors like valuations, earnings reports, and other data.
It’s a risky strategy because, in the end, you might be left holding an overvalued asset when the market corrects itself.
☞ Learn More: Just Buy the Best Business (At a Fair Price)
4️⃣ Odd Lot Theory
The Odd Lot Theory looks at the sales of small blocks of stocks held by individual investors, known as odd lots, to determine when to buy into a stock. The underlying assumption is that small investors are often incorrect in their decisions.
This theory takes a contrarian approach and relies on a simple form of technical analysis – monitoring odd lot sales. The success of an investor or trader following this theory depends on whether they also consider the fundamentals of the companies involved, rather than blindly following odd lot sales.
It’s important to note that small investors aren’t always wrong, and not all odd lot sales signal problems. Individual investors can react quickly to significant news, so odd lot sales can sometimes indicate broader issues in a failing stock, rather than just mistakes by small investors.
5️⃣ Prospect Theory
Prospect Theory, also known as Loss-Aversion Theory, highlights how people’s perceptions of gains and losses can be skewed. People tend to fear losses more than they appreciate gains. When presented with two investment options, individuals often choose the one they believe has a lower chance of resulting in a loss, even if it offers smaller gains.
For example, if given two investment choices – one with a consistent 5% return and the other with a 12% return but with a 2.5% loss in one year – many individuals would opt for the 5% option. This is because they attach greater emotional importance to avoiding the single loss, overlooking the overall greater gains.
Understanding Prospect Theory is crucial for both financial professionals and investors. It emphasizes that emotions often cloud rational judgment. Financial professionals must align portfolios with clients’ risk tolerance rather than just their return expectations. Investors need to overcome the emotional biases highlighted by Prospect Theory to achieve their desired returns.
6️⃣ Rational Expectations Theory
The Rational Expectations Theory suggests that individuals in an economy will make decisions based on what they logically expect to happen in the future. This means that people will invest, spend, and make choices in a way that aligns with their rational beliefs about future events. It’s like a self-fulfilling prophecy where actions today help bring about the expected future outcome.
However, the usefulness of this theory is debatable. For instance, suppose an investor believes a stock will rise and buys it, causing the stock to indeed go up. This situation can be explained outside of the Rational Expectations Theory as well.
An investor might notice an undervalued stock, buy it, and see other investors catching on, driving the price up. This illustrates the main issue with this theory – it can be applied broadly, making it somewhat vague and less informative.
7️⃣ Short Interest Theory
The Short Interest Theory assumes that a high level of short interest in a stock – meaning many investors are betting on its price to fall – is a sign that the stock is due for a correction. Common sense might suggest that when so many professionals and individuals are scrutinizing a stock and shorting it, they can’t all be wrong. However, this theory challenges that notion.
The rationale behind Short Interest Theory is that when short sellers eventually buy back the stock they’ve borrowed and sold short, it creates buying pressure, pushing the stock price upward.
☞ Learn More: What’s Short Selling? (Betting Against the Market)
➤ Final thoughts
In this exploration of investing theories, we’ve covered a wide range of concepts, from technical trading theories like Short Interest and Odd Lot Theory to economic theories like Rational Expectations and Prospect Theory.
Each theory attempts to bring some order to the complex world of buying and selling that drives daily market fluctuations.
While understanding these investing theories can be beneficial, it’s crucial to remember that there’s no one-size-fits-all theory to explain the financial world. Over time, different theories may gain prominence, only to be replaced by new ones. In the realm of finance, change remains the only constant.
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〝Money, like emotions, is something you must control to keep your life on the right track.〞
― Natasha Munson
