Don’t be the Greater Fool: When Investing Gets Theoretical

Go online, turn on the TV, or if you’re real old-school, open a newspaper. Either way, when you go the financials section you’re bound to see the same thing every time: people trying to predict the stock market. Now, of course people are going to try to predict the market; there’s $5.1 trillion traded on the foreign exchange market every day, and billions of dollars in profits to be made – if you can just predict correctly.

You don’t have to look far to see that copious amounts of money are spent on attempting to do exactly that – correctly predicting where the stock market is headed. Hedge funds, banks, news sources, fundamental/technical analysts, and many others pour countless resources into predicting the timing and nature of shifts in the market, but to what extent are they successful?

There have been many theories proposed that examine how the market as a whole behaves, and whether the techniques used by individuals and firms to predict the market are reliable. While some theories do acknowledge the success of certain analytical techniques, others claim that it is simply impossible to predict the direction of the market. With so many different theories out there, all with varying degrees of support, I won’t claim to know which, if any, are correct.

What I will do though, is provide you with general overviews of several popular theories that attempt to describe the behavior of the stock market. Here they are:

Efficient Market Hypothesis:

As one of the most well-known market theories of all time, the efficient market hypothesis states that all relevant information about a particular company is already factored into and contained within its stock price. This means that there is no way to buy an “undervalued” company because every company’s stock price reflects all available information about its value. It also claims that the price of a stock will instantly change to reflect new information about the value of a company.

Critiques of this theory point to market bubbles and crashes such as the late 1990’s tech bubble or the 2008 housing bubble and stock market crash; in these scenarios, stocks were trading at highly inflated values, and prices dropped relatively quickly, suggesting that the true value of the stocks were not what they were trading for before the crash. Other critiques of the efficient market hypothesis argue that investors like Warren Buffett, who has consistently beaten the market over the past 50 years using an approach called value investing, would not exist if the efficient market hypothesis is true, because the whole philosophy of value investing is finding stocks traded at less than their intrinsic value.

In summary: The efficient market hypothesis states that stocks are always traded at prices that reflect all the available information about a company, and that these prices react instantaneously to new information. As a result, no stock is overvalued or undervalued.

Greater Fool Theory:

The greater fool theory is the idea that a stock price can be justified by the fact that there will always be a “greater fool” to willing to purchase that stock for a higher price. This is the ideology investors use when buying into market trends that consist of overvalued investments, like the dot-com bubble, the 2008 housing bubble, or as Conor suggests here, the current tech industry.

Proponents of this theory might be very willing to buy into a trend they know is overvalued with the intention of selling to a “greater fool” later on. This can be very risky though, because at some point the price of a stock becomes too inflated for even the greatest fool to buy, and that’s when the bubble bursts and prices plummet.

Prospect Theory (Loss-Aversion Theory):

Prospect theory (also called loss-aversion theory) comes from behavioral economics, and it assumes that people value losses and gains differently. More specifically, the theory states that people dislike losses more than they like gains, even when the value of the gains and losses are identical.

For example, imagine that someone (Joe) was given the option to either receive $100 flat out, or to receive $150 and then lose $50. In both scenarios, Joe walks away with the same amount of money: $100, but in the second scenario, this involves experiencing a loss first. According to prospect theory, Joe would choose the first option because it does not involve any losses.

This theory ties into the post I wrote last week about how cognitive dissonance affects investment decisions. If prospect theory is correct, then there is even more of a reason to be aware of the effects your subconscious have on your investments. In this case, try to focus on your net gain or loss as of right now, rather than worrying about the smaller gains and losses that you experienced along the way.

Conclusion

You just read about three theories regarding how the stock market behaves: the efficient market hypothesis, the greater fool theory, and prospect theory. They each describe the market in a different way (through prices, interactions, or investor preferences), and they don’t necessarily support each other either – in fact, some of them directly conflict with one another.

So the question is: Now what? What do you do when presented with conflicting information regarding something as daunting and complex as the behavior of the stock market? Honestly, there’s not much you can do other than keep observing, experiencing, and reading about all things related to the market (economics, behavior, analysis, policy, etc.). Sounds like a lot, right?

It is a lot, but don’t sweat it. The Dynalect Team will be here to help you, constantly posting industry reports, along with articles that inform you about current events, investing theory, behavioral economics, market trends, and everything else you might need to help you become a successful investor.

See you next week,

Zach

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