Do Not Invest Without Learning These Interesting Stock Market Theories

"One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute."
William Feather

The stock market is an interesting establishment. While most think it is a zero-sum game, the stock market is very important to the economy. If we ignore the greed and fear, the basic purpose of the stock market is to collect money from those who have it (investors) and give it to those who need it (institutions and companies). Institutions and corporations run the economy of a nation, the global economy as a whole, and drive the human race forward.

However, we cannot ignore greed and fear. Just like capital (funding) is the lifeblood of the economy, greed and fear are etched into the very fabric of the stock market. The stock market is a condensed consensus of thousands of participants. This is what makes it complex, unpredictable, and sometimes irrational.

Hence, there are various theories that try to explain the irrational behavior of the stock market. Not all of them can be deduced by logic. However, the fact that these behaviors are frequently seen in the market is more important than why they happen.

1) The Round Figure

For some strange reason, significantly high buy or sell volume is reached when the stock price reaches a whole number figure.

The most convincing explanation is that investors are humans. And humans are simple beings. Just think of your usual behavior. Why do you keep the alarm at 5 am and not at 5:11?

Because the number 5: 00 is clean, it is neat. It looks and feels like the perfect time to wake up. Interestingly, if the alarm goes off at 5 am but it is already 5:04, some people keep another alarm at 5:30 and go back to sleep. This means that either they love waking up at a neat round figure or they are just lazy.

This behavior is also seen in the stock market all around the world. Keeping Rs. 600 as the target seems neater than keeping a random, obscure figure of Rs. 597. As a result, every investor who kept Rs. 600 as the target will offer to sell at that level, hence creating a huge sell volume.

It is the same with buy orders. Most people like to simplify their calculations. A stock bought at Rs. 150 is easier to keep track of than a stock bought at Rs. 157. You can calculate the percentage gain quickly when you choose a round figure.

Another place where this is seen is when people try to sell their IPO shares. For example, when the IPO shares of Reliance Life Insurance were listed, most people had their targets set at Rs. 500 or Rs. 600 or some other round figure. You obviously did not see many people setting their targets at Rs. 513 or Rs. 609. For some reason, even if people can't sell at these neat prices, their targets are always set at a round figure.

2) The Greater Fool Theory

According to this theory, even if you are wrong about your investment decision, there are high chances of finding someone else who is "more wrong" than you.

Let us assume you buy a stock at a high price today. Even though you bought it at a high price than the stock's real value, there will be another investor who thinks the stock will go even higher. Thus, you can often buy a stock at a high price and sell it at an even higher price to someone who is more optimistic than you.

Now, this theory sounds like fun until it stops being so. At some point or the other, there will be someone who buys at the ultimate peak. While other investors sell and cash their profit, this investor is left with the stock he buys at the highest price. The price only goes down after that. We call this investor the greatest fool.

3) Self-fulfilling prophecy

The stock price is decided by the general consensus of all the market participants. As a result, a stock does what its participants believe it does.

This leads us to something intriguing. If enough participants believe that something will happen, they will take action. Their combined actions will then prove their belief even if the belief was false at first.

Fundamental investors blame technical analysts for insinuating these self-fulfilling prophecies in the stock market. For example, by most technical analysis standards, a stock that crosses over RSI 50 for the first time since long is believed to have entered an intermediate uptrend.

Now, this may not be true at all. But if enough technical analysts are taught this, they will buy a stock at the first sign of it crossing the RSI 50 mark. This will create a huge buyer demand, and the stock will rise indeed.

However, self-fulfilling prophecies can't be called a market flaw. An individual investor cannot say that the general consensus is wrong. If he does, he should place his trade using his own consensus and see if he makes money from it. In other words, investors are here to make money and not to be proved right.

On a humorous note, if enough investors believe that the stock gains when the sun shines brightly. then the stock actually gains if the sun shines brightly. This example explains the self-fulfilling prophecy perfectly.

4) Efficient Market Hypothesis

The Efficient Market Hypothesis is a strong counterargument to fundamental investing.

This hypothesis states that everything that is associated with a company is reflected in its stock price. A fundamentally sound company has this "soundness" incorporated in the stock price itself. If investors expect a good dividend next year, that hope is ingrained in the stock price itself. In short, there is nothing left in a company that is not reflected in its stock price. Thus, a price change in the stock happens only after the addition of a new discovery, news, or change of sentiment.

In other words, the stock market is an efficient establishment and the stock price at any given time correctly reflects the fundamentals, hopes, aspirations, company competence, and management prowess of the corporation. This would then mean that it is a futile attempt to try to analyze the company and find an edge if every edge is already reflected in the stock price.

This is in direct contradiction to fundamental analysis, precisely, value investing. Value investors are always on search of the thing that separates a company from its competitors. Furthermore, they are on the search for this company edge well ahead of other market participants. This enables them to buy the stock at cheap and sell it at a higher price when the market finally sees what they already did.

Nevertheless, given that fundamental/value investing has produced fairly successful investors like Warren Buffett and other renowned "big cats", there is no clear verdict on the efficacy of the Efficient Market Hypothesis.

"In the short run, a market is a voting machine but in the long run, it is a weighing machine."
Benjamin Graham