When it comes to investing, there is no shortage of theories on what makes the markets tick or what a particular market move means. The two largest factions on Wall Street are split along theoretical lines between supporters of the efficient market theory and those who believe the market can be beat. Although this is a fundamental split, many other theories attempt to explain and influence the market, as well as the actions of investors in the markets.
In this article, we'll look at seven common (and uncommon) financial theories.
1. Efficient Market Hypothesis
Very few people are neutral on efficient market hypothesis (EMH). You either believe in it and adhere to passive, broad market investing strategies, or you detest it and focus on picking stocks based on growth potential, undervalued assets and so on. The EMH states that the market price for shares incorporates all the known information about that stock. This means that the stock is accurately valued until a future event changes that valuation. Because the future is uncertain, an adherent to EMH is far better off owning a wide swath of stocks and profiting from the general rise of the market.
Opponents of EMH point to Warren Buffett and other investors who have consistently beat the market by finding irrational prices within the overall market.
2. Fifty Percent Principle
The fifty percent principle predicts that (before continuing) an observed trend will undergo a price correction of one-half to two-thirds of the change in price. This means that if a stock has been on an upward trend and gained 20%, it will fall back 10% before continuing its rise. This is an extreme example, as most times this rule is applied to the short-term trends that technical analysts and traders buy and sell on.
This correction is thought to be a natural part of the trend, as it's usually caused by skittish investors taking profits early to avoid getting caught in a true reversal of the trend later on. If the correction exceeds 50% of the change in price, it's considered a sign that the trend has failed and the reversal has come prematurely.
3. Greater Fool Theory
The greater fool theory proposes that you 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.
Eventually, you run out of fools as the market for any investment overheats. Investing according to the greater fool theory means ignoring valuations, earnings reports and all the other data. Ignoring data is as risky as paying too much attention to it, and so people ascribing to the greater fool theory could be left holding the short end of the stick after a market correction.
4. Odd Lot Theory
The odd lot theory uses the sale of odd lots – small blocks of stocks held by individual investors – as an indicator of when to buy into a stock. Investors following the odd lot theory buy in when small investors sell out. The main assumption is that small investors are usually wrong.
The odd lot theory is a contrarian strategy based off a very simple form of technical analysis – measuring odd lot sales. 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.
Small investors aren't going to be right or wrong all the time, and so it's important to distinguish odd lot sales that are occurring from a low-risk tolerance from odd lot sales that are due to bigger problems. Individual investors are more mobile than the big funds and thus 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-time investors.
5. Prospect Theory (Loss-Aversion Theory)
Prospect theory states that people's perceptions of gain and loss are skewed. That is, people are more afraid of a loss than they are encouraged by a gain. If people are given a choice of two different prospects, they will pick the one that they think has less chance of ending in a loss, rather than the one that offers the most gains.
For example, if you offer a person two investments, one that has returned 5% each year and one that has returned 12%, lost 2.5%, and returned 6% in the same years, the person will pick the 5% investment because he puts an irrational amount of importance on the single loss, while ignoring the gains that are of a greater magnitude. In the above example, both alternatives produce the net total return after three years.
Prospect theory is important for financial professionals and investors. Although the risk/reward trade-off gives a clear picture of the risk amount an investor must take on to achieve the desired returns, prospect theory tells us that very few people understand emotionally what they realize intellectually.
For financial professionals, the challenge is in suiting a portfolio to the client's risk profile, rather than reward desires. For the investor, the challenge is to overcome the disappointing predictions of prospect theory and become brave enough to get the returns you want.
6. Rational Expectations Theory
The rational expectations theory states that the players in an economy will act in a way that conforms to what can logically be expected in the future. That is, a person will invest, spend, etc. according to what he or she rationally believes will happen in the future. By doing so, that person creates a self-fulfilling prophecy that helps bring about the future event.
Although this theory has become quite important to economics, its utility is doubtful. For example, an investor thinks a stock is going to go up, and by buying it, this act actually causes the stock to go up. This same transaction can be framed outside of rational expectations theory. An investor notices that a stock is undervalued, buys it, and watches as other investors notice the same thing, thus pushing the price up to its proper market value. This highlights the main problem with rational expectations theory: It can be changed to explain everything, but it tells us nothing.
7. Short Interest Theory
Short interest theory assumes that a high short interest is the precursor to a rise in the stock's price and, at first glance, appears to be unfounded. Common sense suggests that a stock with a high short interest – that is, a stock that many investors are short selling – is due for a correction.
The reasoning goes that all those traders, thousands of professionals and individuals scrutinizing every scrap of market data, surely can't be wrong. They may be right to an extent, but the stock price may actually rise by virtue of being heavily-shorted. Short sellers have to eventually cover their positions by buying the stock they've shorted. Consequently, the buying pressure created by the short sellers covering their positions will push the share price upward.
The Bottom Line
We have covered a wide range of theories, from technical trading theories like short interest and odd lot theory to economic theories like rational expectations and prospect theory. Every theory is an attempt to impose some type of consistency or frame to the millions of buy and sell decisions that make the market rise and fall daily.
While it is useful to know these theories, it is also important to remember that no unified theory can explain the financial world. During certain time periods, one theory seems to hold sway only to be toppled soon after. In the financial world, change is the only true constant.