What is the Fifty Percent Principle
The fifty percent principle is a technical correction that gives back 50 to 67 percent of the most recent stock price gains before the price begins advancing again. If a stock recently gained 30 percent, the fifty percent principle holds that it will give back at least half of that gain before testing new highs.
Breaking Down Fifty Percent Principle
The fifty percent principle in stock investing is also known as one-half retracement or a technical correction. This is an expected correction that many technical analysts look for before buying resumes at the new lower support levels. Understanding this principle guides other charting techniques when following a stock price bouncing between its support level and new highs.
As an example of the fifty percent principle, shares of Company ABC have gained 30 percent in the past year without undergoing a price correction of more than 10 percent. The trend line looks fairly consistent in its upward trajectory. Toward the top of the trend line the price begins falling back below the previous 10 percent correction level, which according to the fifty percent principle suggests the price will give back at least 15 percent, or half of the 30 percent gain, before resuming its upward movement. Timing these moves up and down allows short-term investors to reap the rewards through their understanding of the many charting concepts widely in use.
This form of chart analysis, as well as others, is most often used in short-term investing. This is because it’s risky to rely mostly on charting for longer periods due to the unexpected impacts of major economic events. These large events, such as the financial crisis of 2008, reconfigure the total economy and markets. An investor who adheres to the fifty percent principle and starts buying after the expected correction occurs may lose money if the price continues downward due to larger events such as a shift from bull market to bear market.
Psychology and the Fifty Percent Principle
Much of investor behavior is driven by psychology, so whether one believes in the various principles such as the fifty percent principle or not, what matters is that many investors do and this drives price momentum. This becomes a self-fulfilling prophecy investors will pay attention to given the desire to move with the herd in making money to the upside and downside.
A fascinating exception to herd mentality psychology can be seen among contrarian investors, who intentionally stray from the herd to place contrary bets that oftentimes are based on fundamental observations and less on charting analysis. The Big Short of the 2008 housing crisis is one example of how a minority of investors bucked the bullish housing trend and made large amounts of money in a matter of weeks by shorting the market.