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Stock market Investment Theories

Saturday, June 23, 2007

There’s a myriad of broad based investment theories within which numerous investment strategies can be implemented. Here we will look at the rationale behind these theories and how they work. As you will see, some theories support the logic behind certain strategies, while other theories negate the possibility that a particular strategy will prove successful.

Efficient Market Theory

Contrary to technical analysis and value investing, the Efficient Market Theory contends that the investment markets are so efficient that all public information regarding a company or its stock gets immediately reflected in its stock price. Based on this premise, there exists no opportunity to discern future market trends or uncover hidden value situations. In other words, a truly efficient market makes it impossible to make trading profits through the use of publicly available investment information, no matter how recent. Since not all investors buy into the pure efficient market scenario, three different forms have developed over the years: the weak, semistrong, and strong hypothesis.

In the weak form, stock prices are assumed to reflect a randomness, with the next trading price likely to be up or down. Historical prices and patterns exert no influence whatsoever on future prices or price direction. While the weak form does admit the possibility of earning above-normal investment returns with a combination of trading strategies, it cannot be accomplished using past prices alone.

Also known as the Random Walk Theory, the weak form gained prominence in the 1960s in the wake of numerous research studies. Much of the work culminated in findings similar to the Brownian Motion Theory found in the physical sciences. Market price variances over time were considered independent of each other, just as minute particles suspended in solution moved independently of each other.

In 1973, Princeton professor Burton C. Malkiel gave Random Walk almost a cult status with his book A Random Walk Down Wall Street (W.W. Norton & Company, Inc. latest edition, 1990). Malkiel provides three characteristics of the efficient market. First of all, an efficient market responds very rapidly to new information. Second, since stock prices are assumed to reflect all available information, it is impossible for investors to use that information for beating the market. Third, investors can’t beat the market except by chance.

In essence, Malkiel claims that the market does not reward information, since it has already been discounted in the stock price, but it does reward risk-taking. Using this risk-taking strategy approach, Malkiel sets out several investment strategies, from out-of-favor stocks to small and neglected stocks.

The semistrong hypothesis says that stock prices accurately reflect all publicly available information regarding a company. All information regarding the firm’s balance sheet, earnings, dividends, etc., have already been taken into account in the company’s current market price. New information on companies, industries, the economy, and so on arrive in a random fashion; therefore, changes in stock market prices also take on a random pattern. It then follows that since the resulting changes in price occur randomly, investors cannot use the information to earn above average returns.

In the efficient market-strong form, no information, either public or private, can help investors consistently earn higher rates of return without assuming greater degrees of risk.

Others have modified the Efficient Market Theory to explain that random pricing does not have to imply the absence of any rational price formation. Under this version, stock market prices are determined by the firm’s earning power, market share, products, dividends, and other fundamental factors, but the randomness in pricing stems from investors’ inability to accurately forecast changes in those factors and their impact on stock prices rather than solely on the market’s efficiency in absorbing information.

This runs counter to the “dartboard mentality” (anyone picking stocks by throwing darts at the financial pages can outperform investors using systems or investment strategies) inherent in the efficient market hypothesis. However, over the years, many dart board portfolios have outperformed the professional money managers.

Whether you subscribe to the Efficient Market Theory in any of its forms or not will have an enormous impact on how you tackle the market.

Cybernetic Analysis

Jerry Felson offers an alternative to the efficient market theory in his book, Cybernetic Approach to Stock Market Analysis (Exposition Press, 1975) in order to bypass its perceived limitations and deficiencies.

According to Felson, the extreme complexity of the stock market and the environment in which it operates as well as inadequate investment tools hamper the investor from earning above-average investment returns.

Using cybernetics concepts (the science and control of communication, and mathematical analysis of the flow of information) and artificial intelligence (advanced cybernetics) techniques, Felson proposes developing judgmental decision-making processes by weighing evidence and formalizing investment analysis.

In plain language, the cybernetics approach automates the investment decision-making process through the use of pattern recognition, learning system theory, and other methods, removing the imperfect human factor and theoretically improving investment returns.

Felson stresses that no investment analysis can be very successful unless it conforms to the law of requisite variety. In other words, the investment decision system must be as complex and as variable as the system (stock market) which it is trying to interpret. According to Felson, this is where other investment systems fail.

While cybernetics cannot yet replace the human factor, it claims to offer better insight into investment analysis than otherwise available and to allow for the development of new investment techniques for superior performance.

Castle-in-the-Air Theory

The Castle-in-the-Air Theory ignores investment intrinsic values and looks to the interpretation and prediction of investor sentiments and actions in order to make their investment positions before the crowd. Lord Maynard Keynes, a respected economist and successful investor, expounded on the theory in 1936. He reported on how investors gravitated away from the hard work of determining intrinsic value to discern how the investing public will act in the future as they build ‘castles in the sky’ based on their hopes and dreams.

Instead of using investment valuation techniques, followers of this theory tried to divine the psychology of the market and where it was headed. It made no difference if a stock currently priced at $25 per share possessed intrinsic value of $30 per share if investors had a negative opinion of the company and their declining demand for the stock would drive its price down to the $20 per share level. Correctly anticipating that market sentiment and shorting the stock would be the proper investment move under the Castle-in-the-Air theory.

Examples of excess mass psychology upsetting all semblance of economic order and rational investment behavior range from the unprecedented surge in gold prices during 1980, when gold rose above $840 per ounce, to the Dutch tulip bulb panic in 1637. Understanding how the crowd thinks and reacts in both normal circumstances and panic situations can deliver a big edge to investors willing to study individual and crowd psychology in relation to the stock market. Market psychology and the herd instinct often play a leading, if not major role in the determination of stock prices and market direction.

Popular investment approaches that use investor psychology as a base include odd-lot theory, contrarian investing, consensus indicators, etc.

Some strategists have even gone so far as to classify investors into specific investment personalities. One such model considers investors falling into one of five classifications ranging from straight arrow to careful to confident to anxious to impetuous, based on personality characteristics such as exhibiting confidence, anxiety, or caution.

Knowing your own personality make-up and how it relates to the investment markets can also help improve your chances of success. Dr. Sully Blotnick, a research psychologist and author of business-related books, developed a profile of the successful investor. According to his theory, the most successful investors tend to concentrate their investments in a narrow range of investments or stocks. Contrary to popular opinion, concentration, not diversification, provides the success edge. Of course, you must balance the degree of risk you are willing to assume with the opportunity for greater returns.

Another trait of the successful investor is the ability to stick with their investment choices and let their profits run. On the other hand, unsuccessful investors tend to follow fads and sell out too soon. Finally, successful investors tend to invest in what they know, industries and companies with which they are already familiar.

Posted by FR at 11:36 PM  

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Investment in equity shares has its own risks. Sincere efforts have been made to present the right investment perspective.The information contained herein is based on analysis and up on sources that we consider reliable. I, however, do not vouch for the accuracy or the completeness thereof. This material is for personal information and I am not responsible for any loss incurred based upon it.& take no responsibility whatsoever for any financial profits or loss which may arise from the recommendations given in this blog.