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The methods used to analyze securities and make investment decisions fall into two very broad categories: fundamental and technical analysis. Fundamental analysis involves analyzing the specific characteristics of a company and industry in order to estimate its value. Technical analysis takes a completely different approach in that it doesn’t care about the value of a company. Technical analysts are mainly interested in the price and volume movements in the market.
The methods used to analyze securities and make investment decisions fall into two very broad categories: fundamental and technical analysis. Fundamental analysis involves analyzing the specific characteristics of a company and industry in order to estimate its value. Technical analysis takes a completely different approach in that it doesn’t care about the value of a company. Technical analysts are mainly interested in the price and volume movements in the market.
Despite all the fancy and exotic tools it employs, technical analysis really just studies supply and demand in the market in an attempt to determine what direction, or trend will continue in the future. In other words, technical analysis attempts to understand the emotions of the market by studying the market itself rather than specific components. If you understand the benefits and limitations of technical analysis you can gain a new set of tools and skills that will enable you to become a better trader or investor.
Technical trading theories are largely based upon short-term trends and odd lot theory, while economic theories are based upon 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 swell and ebb daily. While it is useful to know these theories, it is also important to remember that no unified theory can explain the financial world. In the financial world, change is the only true constant.
Odd Lot Theory
A technical analysis theory that is based on the assumption that the small individual investor always times the market wrong. The odd-lot investor tends to buy a stock at or near is peak, and sell a stock at or near its bottom. If odd lot sales are up, that is small investors are selling stock, it is probably a good time to buy. This approach assumes smaller investors have a low risk tolerance and does not hold a stock long-term.
The Greater Fool Theory
The Greater Fool Theory states that an investor can profit as long as there is a greater fool that will buy the stock at a higher price. This means that you can make money from an overpriced stock as long as someone else is willing to pay more for it.
Investing based upon this theory means that the investor should essentially ignore market valuations, earning reports and all the other data. However, ignoring data is as risky as paying too much attention to it. Eventually you run out of fools as the market, so ascribing to the greater fool theory can leave an investor holding on the “fools” end after a market correction.
Prospect Theory (Loss-Aversion Theory)
The 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 a useful tool 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 creating a portfolio that is suitable to the client’s specific risk profile, rather than their reward aspirations.
Rational Expectations Theory
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, or trade 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 real world application is limited. For example, an investor thinks a stock is going to go up. The investor simply by buying the stock causes its price to go up, becoming in essence a self-fulfilling prophecy. Alongside this, a similar transaction can be framed outside the realm of rational expectations theory. For example, an investor notices that a stock is undervalued therefore buys it. 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 truly tells us nothing.
Short Interest Theory
Short interest theory posits that a high short interest is a precursor to a rise in stock price. Common sense suggests that a stock with a high short interest, which is a stock that many investors are selling short, is due for a correction. The basis behind this thought process is that thousands of professional traders 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.
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 and is 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.
Efficient Market Hypothesis
Very few people are neutral on efficient market hypothesis (EMH). The investor will believe in it and adhere to the broad investing strategies, or 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.
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