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Explained: 5 controversial investing theories that you should know about, and avoid if required

By Finserv MARKETS - Aug 9,2019
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5 controversial investing theories

“If you aren’t thinking about owning a stock for ten years, don’t even think about owning it for ten minutes.”

Credited to the prolific investor and Berkshire Hathaway Chairman Warren Buffet, it is one of the millions of investing quotes, principles, and theories crowding the internet. Investing is a risky activity, but successful investors have time and again proven that it can be made an enriching exercise if done with proper strategy and knowledge. The biggest hurdle before beginners as well as seasoned investors is formulating a winning strategy or following a proven investing theory. It is not possible to discuss every investing theory, but here is a list of five controversial theories, that can be avoided if required.

Efficient Market Theory

At the outset, it must be mentioned that all financial theories are subjective as finance does not follow any proven laws. People have come out with different ideas to explain how the market behaves. The efficient market hypothesis assumes that all stocks are perfectly priced and reflect the true value of their underlying investment properties. In its purest form, the theory maintains that all market participants have equal information, both public and private, so no one has an advantage over the other. The result of the assumption is that the markets are perfect and making an excessive profit is not possible. However, the theory falls short on several counts. Even if there is no disparity in the availability of information, people process the same information in different ways. It is a classic case of “is the glass half full or half empty?”

Fifty Percent Principle

Not much of a theory, but a principle which states that if a stock is on an upward trajectory it will give up at least 50 percent of its recent gains before continuing the surge. For example, if the share price of XYZ Corp has gained 40 percent in two months, without undergoing a correction of over 10 percent, then according to the principle, the stock will give away 20 percent gains or half of the 40 percent appreciation, before resuming its upward movement. The major shortcoming of the theory is that it can be used only for short term investing as it does not take into account the unexpected impacts of sudden economic events like demonetization in 2016.

 

5 controversial investing theories

Source: dummies.com

Greater Fool Theory

The theory is as interesting as the name suggests. It states that profit can always be generated from a stock, even if it is overvalued, as there always will be a bigger fool to buy it at the unsustainable price. If an investor acts in accordance with the theory, he will buy a security without considering its fundamentals and will try to sell it quickly to a greater fool, who in turn, will try to dump it as soon as he buys it. This cycle creates a speculative bubble, which pops sooner than later. Investing according to the theory essentially means ignoring earnings, valuations and all other data, which is extremely risky. Though it is said that the degree of risk taken is directly proportional to the returns generated, smart investors avoid irrational risks. To maintain a balance between risk and reward, one should consider investing in mutual funds. Small amounts invested at daily intervals in a good mutual fund can create a substantial amount in the long run. On Finserv MARKETS, you’ll be able to choose from a variety of mutual funds dispersed across different categories to match your investment targets.

5 controversial investing theories

Source: minimalisttrading.com

Odd Lot Theory

A contrarian investor will definitely develop a liking for the odd lot theory as it is based on the contrarian investing strategy. If one is investing in accordance with the theory, he will buy into a stock when small investors sell out. This theory assumes that individual investors are generally wrong and when they offload a small block of shares, it is advised to buy into the counter. People planning to follow the theory should not buy a security blindly when that odd lot comes for sale, fundamentals of a company should always hold primacy while investing. Small investors are not always wrong or right. Sometimes individual investors exiting a counter could be an advance signal to a wider sell-off as they react to negative developments faster than large funds.

Prospect Theory

A person’s psychology plays a very important role while investing. This theory states that people value potential loss very differently from potential gains. Also known as the “loss aversion theory”, the basic principle is that if an individual is given two options, both equal, one presented in terms of potential gains and the other in terms of potential losses, the individual is highly likely to choose the former. People always try to choose a more certain outcome, this leads to ignoring a probable outcome. This works both ways, individuals avoid risk and higher gains if the other option is a certain gain. On the flipside, individuals seek extreme risk and higher loss when the other option is a sure loss.

Conclusion

We have discussed several theories but not a single one can provide certainty to the market’s behaviour. Millions of trades are executed every second around the world and containing them into broad theories is a futile task. The universal truth is that no theory can predict outcomes in the financial world. Investors should always consider their risk profile before investing. With increasing complications, individual investors should trust professionals to invest on their behalf. Mutual funds invest in a wide variety of stocks, reducing the risk for small investors and generating better returns. You can choose from a wide variety of mutual funds on Finserv MARKETS according to your risk profile.

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