Question

Identify and explain the theories of investor preference?

Answer 1

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There is no lack of ideas about what makes the markets tick, or what a particular market move means when it comes to investing. Wall Street's two main groups are divided along ideological lines between proponents of efficient market theory and those who claim that the market will beat. Although this is a fundamental break, there are many other hypotheses that try to explain and manipulate the economy, as well as investor behaviour in the markets.

1. Efficient Market Hypothesis

On Efficient Market Hypothesis (EMH) very few people are neutral. You either believe in it and stick to passive, broad-based investment strategies, or you detest it and concentrate on acquiring stocks based on growth potential, undervalued assets, etc. The EMH notes that all known knowledge about that stock is included in the market price for shares. This ensures the stock is priced correctly until such time as a potential occurrence changes the valuation. Because the future is uncertain, an EMH adherent is much better off buying a wide range of stocks and taking advantage of the market's overall increase.

EMH critics appeal to Warren Buffett and other investors who have repeatedly defied the market by identifying unsustainable average stock prices.

2. Fifty-Percent Principle

The fifty percent theory assumes that an observed phenomenon (before it continues) should experience a price correction of half to two-thirds of the price change. It means that if a stock is on an upward trajectory and has risen 20 percent, it will fall back 10 percent before its increase continues. This is an extreme example, since this rule is most commonly applied to short-term movements bought and sold by technical analysts and traders.

This downturn is thought to be an inevitable part of the trend, because it is typically triggered by skittish investors taking early profits to avoid being caught up later in a true market reversal. If the adjustment reaches 50% of the price change, it is considered a sign that the pattern has failed and that the turnaround has prematurely occurred.

3. Greater Fool Theory

The bigger theory of foolishness suggests you will benefit from investing as long as there is a bigger fool than yourself in buying the investment at a higher price. This means that as long as someone else is willing to pay more to buy it from you, you might make money from an overpriced stock.

Finally, as the demand for any investment overheats you run out of fools. Investing according to the greater theory of foolishness means ignoring valuations, reports on earnings and all the other details. Ignoring data is as dangerous as paying too much attention to it, so that those who ascribe to the broader principle of foolishness could be left to hold the short end of the stick after a market correction.

4. Odd Lot Theory

The principle of odd lot uses the selling of odd lots–small blocks of stocks owned by individual investors–as an indication of when to buy into a stock. Investors buy in after the odd lot principle while selling out small investors. The key assumption is typically incorrect with those small investors.

The odd lot theory is a counter-strategy focused on a very basic method of scientific research -calculating odd sales of lot. How efficient an investor or trader following the theory depends heavily on whether he is testing the corporate dynamics that the theory points to or is simply blindly purchasing.

Small investors will not be right or wrong all the time, so separating odd lot sales that result from low-risk tolerance from odd lot sales that are caused by bigger problems is crucial. Individual investors are more flexible than big funds and can therefore respond more quickly to severe news, so odd lot selling can potentially be a precursor to a larger sell-off in a failed stock rather than just a small-time investor error.

5. Prospect Theory

The prospect theory may also be referred to as the principle of loss aversion. Theory of expectations notes that the perceptions of gain and loss are distorted by individuals. That is, people fear a loss more than a benefit inspires them. When people are offered an option between two different prospects, instead of the one that provides the most gains, they will choose the one they believe has less risk of ending up in a loss.

For example, if you give a person two investments, one that returned 5 percent each year and one that returned 12 percent, lost 2.5 percent, and returned 6 percent in the same years, the individual will choose the 5 percent investment because he places a disproportionate amount of importance on the single loss, thus ignoring the gains that are of a greater magnitude. In the above example, after three years both alternatives yield the net total return.

For financial professionals and investors, prospect theory is essential. Although the risk/reward trade-off gives a straightforward picture of the amount of risk an investor needs to take on in order to obtain the desired returns, prospect theory teaches us that very few people understand what they scientifically know emotionally.

The task for financial professionals is to tailor a portfolio to the risk profile of the client, rather than to reward the wishes. The task for the investor is to surmount the frustrating prospect theory forecasts and become confident enough to get the returns you want.

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