10 Stock Market Theories Every Investor Should Be Familiar With

If you’re someone who’s interested in investing and wants to learn more about the stock market, you’re in the right place. In this blog post, we’ll dive into the top 10 theories about the stock market that can help you make smarter choices and find success with your investments. We’ll break down each theory and explain how it can be useful for your investment journey.

The Context

In theory, theory and practice are the same. In practice, they are not — Albert Einstein

The majority of stock market literature and posh news items are packed with enigmatic references built around specific theories.

For common investors, few are easy to comprehend but several are confusing. You’re not the only investor if you tend to lose interest when reading these references. A stock market theory is perceived as a carefully thought-out explanation of some observations.

These observations are established by utilizing statistical and analytical techniques that combine several facts and assumptions. Many readers might find the word “theory” boring, so we’ll make an effort to keep our explanations easy yet informative. Without further ado, here is a list of the Top 10 famous stock market theories.

1. Efficient Market Hypothesis

This is one theory you cannot possibly ignore. It’s a “love-hate” drama that has a lot of critics and advocates. The investing fraternity seems to be divided on this theory since the 1940s, like bulls and bears. The efficient market hypothesis (EMH) is one of the milestones in modern financial theory.

It was developed independently by Samuelson (1965) and Fama (1963, 1965), and in a short time, it became a guiding light not only to practitioners but also to academics.

» Short Version

It’s impossible to beat the market as markets are efficient.

» Simple Explanation

The Efficient Market Hypothesis (EMH) essentially says that all known information about investment securities, such as stocks, is already factored into the prices of those securities. The established belief of this theory implies that markets operate efficiently and stock prices instantly reflect all available information.

This stands true upon some high-level reasoning as most participants (investors) receive the same information from some common sources like news websites or company announcements. They respond and react to any new information leading to predictable movements in stock prices. Old information continuously gets factored in and every price tag truly represents the fair price of the stock then.

The theory however has some serious shortcomings. EMH fails to explain extreme volatility in a real-life scenario. Markets oftentimes tend to behave irrationally. The rationale is the unexpected behavior of millions of market participants.

Behavioral finance explains this kind of deviation as an outcome of certain inherent biases and notions that steer an investor’s decision. These biases include overconfidence, overreaction, herd mentality, fear of missing out (FOMO), and information bias. Market bubbles are proof that markets are not (and never will be) efficient.

You may read more about EMH in our free Stock Investing course.

2. Greater Fool Theory

While many smart investors base their investment choices on an asset’s intrinsic value, this theory contends that this is not always the case.

» Short Version

An asset bought at an expensive price can be resold at an even higher price to the greater fool!

» Simple Explanation

As per the greater fool theory, a foolish investor can sometimes make money by purchasing overvalued stocks or assets. Stocks purchased at a ridiculously higher value can presumably later be resold at an even higher price to some other fool.

This stands true during market bubbles because the frenzy and greed lead to finding someone willing to pay a rather ludicrous price for an expensive asset. With no means of identifying the true intrinsic value, Bitcoin may be assumed a classic case of the greater fool theory.

Bitcoin investors believe that due to limited supply, the value of this asset will keep going up in the future. Someone at some point will offer them a higher price for their holdings.

3. Random Walk Theory

The random walk theory was conceived by Burton Malkiel in 1973 in his book “A Random Walk Down The Wall Street”. The random walk theory is partially similar to the efficient market hypothesis (EMH), as both theories concede that it is impossible to outperform the market.

» Short Version

The stock market moves in a completely unpredictable way.

» Simple Explanation

Random Walk theory is a hypothesis that states that stock prices can never be predicted reliably. The price of the stocks can take a random walk like a drunken man. They can even be influenced by irrelevant information that has nothing to do with the market. The random walk theory also implies that it is only possible to outperform the market by taking additional risks.

Followers of the Random Walk theory often support the idea of investing passively in the index or mutual funds rather than unnecessarily risking capital by cherry-picking or trading stocks.

4. Dow Theory

The core of the almost 255 publications Charles H. Dow authored can be summed up as The Dow Theory. He was the man behind the Dow Jones financial news service (Wall Street Journal). Charles H. Dow is also referred to as the father of Technical Analysis.

» Short Version

Maximum and minimum market fluctuations can be used to make accurate predictions on the direction of the market.

» Simple Explanation

Dow theory tries to demystify what phase the market is in and is said to help make predictions about what is going to happen next. The Dow Theory is built on a few principles and these are usually referred to as the ‘Dow Theory tenets’.

The six tenets of Dow theory are as follows-

≡ Market Discounts everything

≡ Market Has Three Trends

≡ A Trend Has Three Phases

≡ Indices Must Confirm Each Other

≡ Volumes Should Confirm Trends

≡ Trend Should Continue Until Clear Reversals

This century-old theory continues to remain relevant in current markets.

5. Behavior Finance Theory

To provide answers to why people make irrational financial decisions, behavioral finance theory, a relatively recent idea, aims to blend classical economics and finance with behavioral and cognitive psychological theory.

» Short Version

Behaviour Finance Theory suggests that an investor’s emotions heavily influence his investment decisions.

» Simple Explanation

Almost all common investors have similar access to commonly available data and information. Yet many fail to realize their full potential.

Why is it that some individuals prefer to examine complex numbers while some waste their valuable time on social media forums seeking easy tips and unsolicited advice? This contrast is largely ridden by certain behaviors and biases, and that’s all there is to this theory. The theory further explains that markets fail to reflect true fundamentals because investor decisions are driven by underlying biases. These biases often lead to irrational behavior.

This theory is an outcome of the probability theory developed by Daniel Kahneman and Amos Tversky. Interestingly, Kahneman and Tversky were both psychologists with no or little training in classical finance! A few of the cognitive biases that are at play inside the psyche of an investor are Confirmation, Information, Loss Aversion, Hindsight, and the Bandwagon effect.

6. Fifty-Percent Principle

This theory is also known as a one-half retracement. Although it’s up for debate, consider testing this theory with any equities you may have bought during the corrections observed during March of 2020 (COVID scare).

» Short Version

The fifty percent principle predicts that an observed trend will undergo a price correction of one-half to two-thirds of the price change.

» Simple Explanation

This theory is predicated on the idea that trend corrections are a normal occurrence. This means a Stock on an upward trend will lose 50% to 75% of its recent gains before extending its upward journey ahead. This 50% decline is due to the investors who tend to sell their shares after seeing an upward trend. These investors are concerned a lot and believe security or stock has now become overvalued.

When they realize that the growing trend is resuming again after a steep fall, they buy the security back. While still debatable, the fifty-percent Principle is commonly used by short-term traders.

7. Odd Lot Theory

The odd lot idea is as accurate as it is bizarre. During the 1960s and 1970s retro era, this notion attracted a lot of attention. Stocks are usually traded in increments of 100. Any order that’s executed below the standard set value of stocks is known as an odd lot.

» Short Version

The odd lot theory is concerned with the behaviors of individual investors who trade odd lots.

» Simple Explanation

Odd Lotter is a term that defines small investors who purchase stocks in small and random quantities like 37, 16, 7, etc. basis their affordability. This theory believed that smart investors could outperform the stock market by identifying the trends generated by least-informed investors and making investments opposite to them. If odd lotters were selling, professional traders would buy, and vice versa.

The actions of odd lotters were interpreted as contrary signals. Due to the development of mutual funds, exchange-traded funds, and the use of intelligent order-matching algorithms on stock exchanges, the idea is no longer accurate.

8. Prospect Theory

Prospect theory, also dubbed loss-aversion theory, is the psychological theory of decision-making under conditions of risk. This theory can be considered an extension of behavioral finance theory and was also developed by psychologists Daniel Kahneman and Amos Tversky during the 1970s.

This model surprisingly goes beyond stock markets and investing and is also used to analyze various aspects of political decision-making, especially in international relations.

» Short Version

Prospect theory states that decision-making depends on choosing among options that may themselves rest on biased judgments.

» Simple Explanation

Prospect theory is formulated to explain a common pattern of choice, especially the ones that involve risk and uncertainty. The term ‘Prospect’ in this theory refers to the predictable results of a lottery. Theory suggests that people value gains and losses differently, and will always base their decisions on perceived gains rather than perceived losses.

For instance, most individuals would prefer winning ₹100 with certainty rather than taking a risky bet in which they can toss a coin and either win ₹200 or nothing. In layman’s terms, according to prospect theory, losses have a more emotional impact than an equivalent amount of gains.

To find out if you are risk-averse or not, please respond to our wonderful challenge below and leave your opinions in the comments below.

Question —You have ₹1,000 and you must pick one of the following choices.

💫 Choice A — You have a 50% chance of gaining ₹1,000 and a 50% chance of gaining ₹0

💫 Choice B — You have a 100% chance of gaining ₹500

9. Rational Expectations Theory

The theory of rational expectations was first proposed by John F. Muth of Indiana University in the early 1960s. He used the term to describe several economic situations in which the outcome depends partly on what people expect to happen.

This theory is a cause-and-effect paradox, and thus we will try to articulate it with a simple example.

» Short Version

The concept of rational expectations asserts that outcomes do not differ regularly or predictably from what people expected them to be.

» Simple Explanation

As per this theory, when making decisions, investors will base their rulings on the currently available information along with learnings from the past (preceding mistakes). With this notion, although investors may be wrong some of the time, collectively and on average they will be correct.

Consider deciding against buying a particular stock because you believe the price will stabilize by the end of the month based on historical and current data. Imagine those other market players also go through the same thought process. The demand for stocks will eventually wane if enough investors see the same thing after looking at the same set of data, and the stock price is likely to decline as a result.

10. Day-Of-The-Week Investing Theory

Infinite statistical likelihoods support this contentious idea.

» Short Version

The theory is based on a common belief that one should buy stocks on a specific day of the week for better returns.

» Simple Explanation

A notion known as day-of-the-week investing contends that particular days of the week are better for buying or selling equities. This happens because statistical analysis gives the appearance that these specific days outperform all others.

Monday effect is an example of this belief where many investors assume that stock prices tend to be the lowest on Mondays as compared to the rest of the week. This theory negates the theory of the Efficient Market Hypothesis (EMH) and is hence despised by most EMH proponents. Any day is a good day to buy stocks, in our opinion. Long-term vision flattens out the turbulence and outpaces the influences (if any) of good or bad days, weeks, and months.

Conclusion

A theory is a comprehensive account of a phenomenon based on actual events, observations, and data.

It’s the theories that tend to provoke every intelligent investor to explore beyond literary deliberations.

Many investors take certain stock market beliefs as “golden rules,” but perhaps it’s time to reconsider! A wild prediction based on fresh facts, observations, and data may be made using stock market theories, but they are unreliable for predicting likely events. This brings us to the end of our top 10 list of stock market theories.

We’d love to know what you think about this assortment in the comments below.

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Invest wisely!