Investing in Theories

While gut feeling appears to be the prevalent ‘theory’ governing investment decisions, there are numerous theories that attempt to explain the market. Probably the most common theory in circulation is the efficient market hypothesis.

The efficient market hypothesis 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 this theory is far better off diversifying stock holdings and profiting from the general rise of the market. Basically proponents in this theory tend to prefer investment in ETF’s that replicate the market index.

However, most investors believe that they can beat the market. The following theories are the most common theories that form the basis of investment strategies.

Fifty Percent Principle

Proponents of this theory observe that before continuing, a 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 10%, it will fall back 5% before continuing its rise. Technical analysis is of used in support of this theory.

Greater Fool Theory

This is as interesting one! There is always a ‘greater 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 the market will run out of fools as the market for any investment overheats. Investing according to the greater fool theory means ignoring valuations, earning reports, other data and probably common sense.

Odd lot Theory

The main assumption behind the odd lot theory is that small investors are usually wrong. Investors following the odd lot theory typically follow the supply of ‘small lots, and buy in when small investors sell out.

Prospect 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, they will pick the one that they think has less chance of ending in a loss, rather than the one that probably offers the most gains.

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.

Rational Expectations Theory

Rational expectations theory states that the players in an economy will act according to their individual rational expectations creating a self-fulfilling prophecy that helps bring about the future event.

Short Interest Theory

Short interest theory posits 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.

However, proponents the theory point to the fact that as the price goes down basic economic theory dictates that interest in the stock will increase. At some point large players will enter the market and short sellers will cover their positions resulting in a rally.