Even if you don’t agree with a specific investment theory, or regard it as a blatant over-simplification, it can still be good to know about it because it can help you understand why certain other investors behave as they do. After all, stock prices are determined by investors willingness to pay, so understanding how other people may think and assess a situation is crucial.
Below, we will take a quick look three well-known investing theories.
The Halloween indicator
According to the Halloween indicator, the period from Halloween to the end of April will have stronger average growth than the period from early May until Halloween. People adhering to this theory tend to sell stocks in early May and not purchase new stocks until October/November. This has given rise to the phrase “Sell in May and Go Away” since these investors leave the stock market during the summer and early fall.
The 50% principle
This theory states, that a trend will undergo a major price correction before continuing, and that the size of this price correction will be between one-half and two-thirds of the price. Calling it the 50% to 67% principle would be bit cumbersome, so it is known as the fifty percent principle.
Example: Stock in Company ZZZ has been on an upward trend and gained 20 percent. According to the fifty percent principle, it will fall back with at least 10 percent before continuing to rise.
People adhering to the fifty percent principle are not alarmed when they notice that they price is going down, because they see this price correction as a natural part of the upward trend. For them, it is only natural for certain investors to take profits early in an upward trend, thus causing a temporary downturn in the price.
If the correction exceeds 2/3, it is seen as a warning that the correction has turned into a real downturn ant that the trend is probably over and wont continue.
Odd Lot Theory
A proponent of odd lot theory will keep a keen eye on small blocks of stocks held by individual investors. When odd lot sales are up (i.e. when the small investors are selling stock), the odd lot theory-adherents move in an buy. The general idea is that small investors are usually wrong.
Some people use this theory to buy rather blindly, while others combine it with other methods, e.g. analyzing the fundamentals of interesting companies and then use the odd lot theory simply to time the purchase of suitable company stock.
Loss Aversion Theory
According to the loss-aversion theory, humans are more afraid of loss than encouraged by gain. This theory is based on experiments where subjects have been given a choice of two different prospects, and where a majority have picket the alternative that they think has the least risk of ending in a loss rather than the alternative that they think has the largest chance of ending in the biggest win.
Example: Mr Smith is offered two investments. Investment A has given a return of 5 percent during the last three years. Investment B gave a 12 percent profit during the first year, caused a 2.5 percent loss in its second year, and gave a 6 percent profit in the third year. According to loss-aversion theory, Mr Smith will be more likely to pick Investment A than Investment B, even though they gave the same net profit during the last three years.