List of controversial investment theories
There are many theories explaining the bursts and general market movements. Wall Street is divided into two large groups – supporters of the theory of market efficiency and its opponents, who believe that the market can be won. Of course, this is the most striking example of controversy, but there are many other theories that try to explain the market and influence it through investors. In this article we will consider some typical (and non-typical) financial theories.
Market Efficiency Theory
Very few people are neutral about the theory of market efficiency. You can either believe in it and stick to passive market-wide strategies, or you can join a group of opponents and focus on finding shares with growth potential, undervalued assets, etc. According to the theory of market efficiency, the market price of shares takes into account all available and significant information. This means that the price of a share currently corresponds to its real value and will not change until new events occur. Since the future is unknown, supporters of market efficiency theory are trying to acquire a small number of shares, and are aimed at making a profit from the overall market growth. Opponents of market efficiency theory cite the example of Warren Buffett and other investors who were able to surpass the market by using undervalued shares in the common market of investment instruments.
Principle of 50 per cent
According to the principle of 50 percent, the continuation of any trend takes place after the price correction by 1/3 – 2/3 of the previous price movement. This means that if a share rises by 20%, its value will be adjusted by 10% before the upward movement continues. The observed correction is considered to be an integral part of the trend, which is caused by the actions of scared traders who are afraid of a trend reversal and who fix open positions. Excess correction of 50% of the previous price movement can be considered as a sign of a rapid trend reversal
The bigger fool’s theory
According to the theory of a bigger fool, an investor can profit from a long position opened until there are “big fools” buying an asset at a higher price. This means that you can keep an overvalued share until you find a new buyer who can pay a higher price for it and buy it back from you. As a result, you get out of the foolish society before the market overheats. Investment according to this method implies ignoring various fundamental data, which carries high risks and may leave the investor out of business after the next market correction.
The theory of incomplete lots
According to the theory of incomplete lots, the investor is looking for opportunities to enter the market by analyzing the actions of small private investors. Adherents of this theory buy at the moment when small investors sell, and vice versa. The theory of incomplete lots is based on the assumption that small investors are always wrong. The theory of incomplete lots is a strategy of entry against the market, based on a very simple technical analysis – the evaluation of transactions with incomplete lots. The success of an investor or trader using this theory depends mainly on the analysis of fundamental data of the companies. Small investors cannot be wrong or right all the time, so it is necessary to distinguish mistakenly open and correctly opened incomplete lots. Private investors have more freedom than large investment funds, so they react more quickly to the news, can open unmistakably in the direction of the market and become the precursors of a strong market movement.
Theory of Perspectives (Theory of Fear of Losses)
According to the theory of prospects, traders perceive profits and losses differently. This is due to the fact that the fear of loss is a much stronger feeling than the joy of making a profit. If a trader has a choice between several investment opportunities, he or she will choose an option with a minimum probability of loss, rather than an option with a probability of maximum profit. For example, if you offer 2 investment options to someone – the first option with 5% annual profit and 2.5% loss probability, and the second option with 12% annual profit and 6% loss probability, the person will choose the first option, because it gives too much importance to a single case of loss and ignores the possibility of compensation for losses at the expense of greater profitability. In the above example, in terms of lump-sum losses, both options become equivalent after three years.
The theory of perspectives is of great importance for professional financial specialists and investors. While the assessment of the return on risk ratio provides a pretty clear picture of the risk an investor takes to achieve a certain level of return, the outlook theory confirms that only a few of us really understand what they are doing in practice. For example, the task of financial professionals is to form a portfolio that meets the risk levels set by the client. The investor should be aware of the existence of the theory of prospects and try to overcome his fears in order to get the level of profit that would suit him
Theory of rational expectations
According to the theory of rational expectations, market participants act in accordance with the logically expected future market conditions. In this way, the person tries to achieve success through forecasting and manages his assets in accordance with his rational expectations. Although this theory is prominent in economic theory, its usefulness is questionable. For example, if an investor thinks that the value of a share will rise, he buys it and as a result of buying it the value of the share actually rises. This situation can be explained beyond the scope of the theory of rational expectations. An investor observes that a share is undervalued, buys it and observes how other investors also begin to invest in the same share, pushing the share price to fair values. This is the main problem of the theory of expectations – it can explain any events, but does not have any predictive usefulness
Theory total short position
According to the theory of total short position, after large-scale short sales of shares follows a period of growth in their value. Common sense suggests that actively traded shares – shares that are subject to active short selling – will eventually adjust upwards. Of course, one cannot say that thousands of professional traders and private investors, who scrupulously analyze market data, are wrong. In principle, they are right, but the value of the share may increase due to excessive sales. Traders must eventually close their short positions and have to buy shares to do so, which creates upward pressure on their value
We have considered many different theories related to technical analysis (total short position theory and incomplete lot theory) and economic theories (rational expectations theory and perspective theory). Each theory is a kind of attempt to impose patterns of behavior on traders in the market for its daily swaying. Of course, it is useful to know these theories, but it should be understood that there are no ready-made recipes for success in the financial world. The theory that prevails over time can be overthrown overnight. The only thing that is constant in the financial world is constant change