When it comes to investing, people tend to have different ideas about what is the best strategy to use to make money. The opinions could be split in two big groups: the supporters of the efficient market theory and those who believe they can beat the market.
There is not a wrong or right way to invest, as long as the strategy works best for the individual investor and provides a good return. In the following article, we will examine some of the most prevailing and both controversial investing theories.
1. Efficient Market Hypothesis
The only approach an investor could follow in order to possibly obtain higher returns is just by purchasing riskier investments.
The Efficient Market Hypothesis assumes that all stocks are perfectly priced (at their fair value) according to all available information. In other words, it is impossible to either purchase undervalued stocks or sell stocks for inflated prices. The only approach an investor could follow in order to possibly obtain higher returns is just by purchasing riskier investments.
In the real world, however, we don’t have an absolutely efficient market, and that is why there exist persons who seek outstanding profits: they represent the main force that “keeps the wheels of the market turning”. Warren Buffett is the best example for proving that the market can be beaten. His investment strategy focused on undervalued stocks.
2. Fifty Percent Principle
The general idea of the Fifty Percent Principle is that a security on an upward trend will lose 50% to 75% of its recent gains, before the upward trend extends. This ½ decline is due to the investors that sell their shares after seeing an upward trend, because they are concerned that the security is overvalued. When they realize that the growing trend continues, they buy the security back.
3. Greater Fool Theory
The main problem with this theory is that, at some point, you run out of fools.
"Every once in a while, the market does something so stupid it takes your breath away." - Jim Cramer
The Greater Fool Theory assumes that there will always be someone - an even greater fool - that will be ready to overpay for a stock that is already overpriced. This theory is helpful especially for highly speculative equities, with “fancy” names, but few earnings, like Japan’s Bubble Economy in the 1980s, or the Dotcom Bubble (Internet stocks in the 1990s). The main problem with this theory is that, at some point, you run out of fools. The price will collapse, because no one will buy such an overpriced stock.
4. Prospect Theory
The Prospect Theory is a behavioral model that suggests that people are more fearful of a loss than they are encouraged by a gain. Having a choice of two different prospects, an individual would pick the one that he/she thinks has less chance of ending in a loss, rather than the one that offers the most gain. This is what investors should realize and try to behave like that: not all people understand emotionally what they realize intellectually. The challenge is to overcome that.
5. Odd Lot Theory
The Odd Lot Theory bases on the idea that, in general, small independent investors - “odd lots” (buy less than 100 shares) are usually the least-informed and do not make wise decisions. As a consequence, those who follow this theory, will make an investment opposite to those “odd lots”.
However, data does not always provide evidence for this theory. Individual investors have the advantage of being more mobile than the big funds, and they could react faster upon an alarming situation in the market. Particularly, odd lot sales could sometimes represent a larger sell-off, than a mistake of small-time investors.
Investment is a precarious, and, in the same time, a very interesting activity. A lot of people try their chances, but it takes a lot of time, knowledge, research and luck to get expansive profits.
In the end, everybody, by trying, should decide what is the best theory that he/she can rely on when investing. However, my personal opinion associates with that of Ben Graham: "The individual investor should act consistently as an investor and not as a speculator."