7 controversial investment theories

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When it comes to investing, there is no shortage of theories about what makes markets tick or what a particular market move means. The two largest factions on Wall street are theoretically divided between supporters of the efficient market theory and those who believe that the market can be beaten. While 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.

The central theses

  • Financial markets have been described by formal economic models based on several theoretical frameworks,
  • The most ubiquitous model, the efficient markets hypothesis, remains controversial as reality does not always match theoretical assumptions.
  • Other theories do not rely on rational actors or market efficiency, but rather on human psychology and emotions.

1. Efficient market hypothesis

the Efficient Markets Hypothesis (EMH) remains a topic of discussion. The EMH states that the market price for a stock contains all known information about that stock. This means that the stock will be priced accurately until a future event changes that rating. With the future uncertain, it is much better for EMH supporters to own a broad block of shares and benefit from the general boom in the market. You either believe in it and adhere to passive, broad-based investment strategies, or you loathe it and focus on choosing stocks based on growth potential, undervalued Fortune and so on.

Opponents of EMH show Warren Buffett and other investors who have consistently beaten the market by finding irrational prices in the overall market.

2. Fifty percent principle

the Fifty percent principle predicts that (before continuing) an observed trend will experience a price correction of half to two thirds of the price change. This means that a stock that has been trending up and is up 20% will fall 10% behind before resuming its climb. This is an extreme example as most of the time this rule is applied to short term trends that technical analysts and traders buy and sell on.

This correction is seen as a natural part of the trend as it is usually caused by scared investors who take profits early to avoid falling into a real crisis reversal of the trend later. If the correction exceeds 50% of the price change, this is considered a sign that the trend has failed and the trend reversal has occurred prematurely.

3. The greater fool’s theory

the Greater Fool Theory suggests that you can benefit from investments as long as there is a bigger fool than you to buy the investment at a higher price. That means you can make money on an overpriced stock as long as someone else is willing to pay more to buy it from you.

At some point you will run out of fools as the market overheats for any investment. Investing on the greater fool’s theory means ignoring it Reviews, score reports and all other data. Ignoring data is just as risky as paying too much attention to it, and so people attributed to the bigger fool theory might keep 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 shares held by individual investors – as an indicator of buying a stock. Investors who follow the odd lot theory buy when retail investors sell out. The main assumption is that retail investors are usually wrong.

The odd lot theory is a contradictory Strategy based on a very simple form of technical analysis – Measurement of quota sales. How successfully an investor or trader follows the theory depends heavily on whether they are reviewing the fundamentals of companies pointed to by the theory or whether they are simply buying blindly.

Retail investors will not always be right or wrong, and so it is important to distinguish odd-lot sales that occur with a low tolerance for risk from odd-lot sales that are due to larger problems. Individual investors are more mobile than the big funds and can therefore react more quickly to serious news, so odd lot sales can actually be a harbinger of a wider sell-off of a failing stock, rather than just a mistake by retail investors.

5. Prospectus theory

Prospecting theory can also be referred to as loss aversion theory. Perspective theory states that people’s perceptions of gain and loss are skewed. That is, people fear a loss more than they are encouraged by a gain. When people have a choice between two different perspectives, they choose the one that they think has less chance of losing than the one that offers the most gains.

For example, if you offer a person two investments, one with a return of 5% per year and one with a return of 12%, a loss of 2.5% and a return of 6% in the same years, that person will choose the investment 5% because it attaches irrational importance to the individual loss while ignoring the gains that are greater. In the example above, both alternatives create the network Total return after three years.

Prospect theory is important for finance professionals and investors. Although the risk-reward balance gives a clear picture of how much risk an investor must take to get the desired returns, prospectus theory tells us that very few people understand emotionally what they are intellectually realizing.

For finance professionals, the challenge is to tailor a portfolio to match that of the client Risk profilerather than rewarding wishes. For the investor, the challenge is to overcome the disappointing predictions of prospectus theory and become brave enough to achieve the desired returns.

6. Theory of Rational Expectations

the Theory of Rational Expectations states that the actors of an economy will act as it can logically be expected in the future. That is, a person will invest, spend, etc. according to their rational assumption that it will happen in the future. In doing so, that person is creating a self-fulfilling prophecy that will help bring about the future event.

Although this theory has become quite important to economics, its usefulness is dubious. For example, an investor thinks that a stock is going to go up, and by buying it, that act actually causes the stock to go up. The same transaction can be classified outside of the theory of rational expectations. An investor notices that a stock is undervalued, buys it, and watches other investors notice the same, driving the price up Market value. This highlights the main problem with rational expectations theory: it can be changed to explain anything, but it tells us nothing.

7. Brief interest theory

Short interest theory assumes that high, short interest rates are the precursor to a rise in the share price and appear unfounded at first glance. Common sense suggests that a stock has high short interest – that is, a stock that many investors are Short sales– a correction is due.

The reasoning is that all of these traders, thousands of professionals and individuals examining every scrap of market data, certainly cannot be wrong. They may be correct to some extent, but the stock price may actually go up because they are heavily shorted. Eventually, short sellers have to cover their positions by buying the stocks they shorted. As a result, the buying pressure created by the short sellers covering their positions will drive the stock price higher.

The bottom line

We have covered a wide range of theories, from technical trade theories such as short interest and odd lot theory to economic theories such as rational expectations and prospect theory. Each theory is an attempt to impose some kind of consistency or framework on the millions of buying and selling decisions that make the market rise and fall every day.

While it is useful to know these theories, it is also important to remember that no single theory can explain the financial world. During certain periods of time, a theory seems to hold its own, only to be overthrown shortly afterwards. In the financial world, change is the only real constant.


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