On television and in movies, investing in the stock market is often portrayed as a two-dimensional process where success is simply a matter of buying low and selling high. Of course, the essence of any type of investing is to sell what you have for more than it cost you. The question is how you arrive at that point.
Legendary investor Benjamin Graham created the concept of value investing, which utilizes a detailed financial evaluation of individual companies to determine their worthiness for investment. Graham’s method relies on hard data about companies, referred to as their fundamentals.
Graham and his investing progeny consider balance sheets and income statements to be the bedrock of investment decision making. And fundamental investing is at the opposite end of the investing spectrum from many of the strategies and theories outlined here.
At their heart, these strategies are controversial because they use different technical methods to predict how the market is going to behave rather than the financial soundness of individual businesses.
Efficient Market Hypothesis
This investment strategy is controversial for several reasons, but they are best summed up by its assertion that the most successful investor of all time, Warren Buffett, could not exist!
You read that right: According to the efficient market hypothesis, it is impossible for an investor to “beat the market” consistently. With some luck, outperforming the market once in a while can happen, but not without exposure to greater risk.
The efficient market hypothesis is based on the premise that there is no such thing as an undervalued stock. EMH argues that predicting market trends by gauging the intrinsic value of a stock from its qualitative and quantitative factors isn’t necessary.
The EMH says markets are efficient, and that collective wisdom or insight by investors is at work at all times. It says that collectively they have access to all available information and, therefore, stocks are almost always priced at their correct, fair-market value.
The chief controversy of the EMH is exemplified by events like the stock market collapse of 2008. The hypothesis incorrectly says the stocks of companies that dropped 20% or more in a single day were an accurate representation of the value of those companies. For the theory to be sound, it must apply to all circumstances and events like the crash, which proved the markets are not always efficient.
This is an almost completely technical investing strategy because it’s based on changes in the market rather than on buying and selling stocks based on a company’s underlying value.
Technical traders chart a stock’s price changes over time in order to identify trends. Trends are sustained movements of a stock’s price, either up or down. They can vary in duration from one to five days for short-term trends to several weeks or months or even years for long-term trends. Some aggressive technical traders will look for very short-term trends that can occur during the course of a single trading day.
Devotees of the 50% principle believe trends are periodically interrupted by price corrections that range from one-half to two-thirds of a stock’s change in price. An exaggerated example would be a stock that is trending upward in a trader’s chart. It’s trading at a premium of 20%, but will experience a drop of 10% before it resumes its upward trajectory. The stock losing half its gain is where the principle gets its name.
The principle further holds that if a stock’s price drops by more than 50%, it may signal an end to the trend. The controversy is that the drop in price is looked upon as a natural occurrence — instead of investors simply cashing in on their gains.
Risk Parity Strategy
A traditional investment portfolio is often based on a 60%/40% split between stocks and bonds, and is focused on economic growth as the catalyst for portfolio growth. A risk parity portfolio seeks to balance risk and thus provide more consistent returns across a variety of market conditions.
Risk parity strategists will allocate resources among stocks, bonds, commodities, and interest rates in an effort to normalize risk. The downside of the risk parity investment approach is that it may not perform as well as a traditional portfolio in a bull market. However, advocates say this is compensated for by its superior performance during bear markets.
The risk parity strategy was first employed in 1996 by Bridgewater Associates’ All Weather hedge fund which, like all risk parity-based portfolios, uses volatility (uncertainty in price) as a measure of risk.
Risk parity strategists will seek investments that perform differently from one another in order to even out the level of risk. By balancing lower returns of consistently appreciating investments like bonds with higher-performing stocks, they aim to achieve a more consistent result.
Loss Aversion Theory (Prospect Theory)
This is less an investment strategy than a theory about investing behavior. It is important and controversial because of its potentially profound effect on how individuals invest. Called loss aversion theory, it’s based on the premise that most investors will favor an investment that has a perception of potentially smaller gains if it means a reduced risk of loss.
The theory looks like this: An investor is offered two mutual funds, one of which has had a consistent 5% return over the past three years and another that has had returns of 12%, minus-3%, and 6%. The theory says most investors will choose the first fund, despite the fact that they have identical net returns, because the first fund appears to be less risky.
The controversy centers on the relevance of understanding investing behavior as a means of improving investment performance. The theory says the goal should be to reduce or eliminate emotion as a basis for investment decisions. By overcoming the emotional reflex of placing overweighted importance on negative prospects, investors will be able to use dispassionate intellectual analysis to make decisions.
Rational Expectations Theory
This theory says people base their view of the economy in general and how they invest based on what they rationally expect to happen in the future, using a combination of available (though not necessarily complete) information and past experience.
The theory further states that the economy will perform, at least partially, based on expectations rather than facts. The result is a sort of self-fulfilling economic prophecy.
While the theory is primarily an economic one, it has also been applied to investment analysis on the premise that if investors believe a stock will go up in value, it will as a result of the rational expectations of investors. The controversy at the heart of this theory is that it can be used to explain nearly any market behavior, and therefore has no utility.
Leveraged ETF Strategy
ETFs are exchange-traded mutual funds designed to be diversified enough as to reflect the market or a segment of the market. They were created as a means for investors to bet on the movements of the market as a whole, or segments within it.
A common misconception about ETFs in general is that they are composed of all the stocks traded on a given exchange or within a particular sector. In reality, ETFs are composed of stocks that are considered representative of the market or sector, which is why they may not always match the performance of the market as a whole.
The goal of a leveraged ETF, meanwhile, is to outperform the market by providing a return that can be as much as two to three times greater than the index (market or sector) it’s tied to.
Leverage is an investment term for borrowing money. Leveraged ETFs typically use derivatives to borrow money in order to increase their purchasing power and, in turn, generate exaggerated returns — whether gains or losses. The use of derivatives to create leveraged ETFs functions in a similar manner to a car buyer who puts down 10% of their own money and borrows 90% of the purchase price of a car. Leveraged ETFs bet that, unlike a new car that loses value as soon it drives off the lot, their purchases will increase in value at a greater rate than the underlying interest.
Using our car analogy, it’s like using $2,000 of your money, combined with a loan for $18,000, to buy a car for $20,000 that you can drive off and resell for $22,000, netting yourself a profit of $2,000 (minus a small amount of interest on the loan).
This same strategy enables leveraged ETFs to buy more stocks than they could otherwise and increase their return on investment above and beyond the increase in market price because they are buying more stock than they have money to buy.
The controversies surrounding leveraged ETFs mostly revolve around their potency — their ability to augment market gains means they can also generate exaggerated losses — and the derivatives used to fund them. That’s because the derivatives are often highly complex financial instruments that are surrounded by questions about how they are calculated, and thus the returns they generate may become suspect.
Greater Fool Theory
This investment strategy is almost always entirely technical since it ignores the data and is premised on the belief that there will always be someone willing to pay a higher price for a stock.
Like a game of liar’s poker, the original investor gambles that someone else is willing to raise their bet and pay a higher price. The potential buyer is considered the greater fool because they would be buying an overvalued investment based on the same lack of knowledge as the original buyer.
The greater fool investment cycle ends in much the same way as liar’s poker — when the succession of fools dries up because the probability of gain runs out of steam. The controversy stems from the fact that investing based on a lack of information is a riskier proposition than overanalyzing data.
Short Interest Theory
Short selling occurs when investors believe the price of a stock is going to decrease. For example, if I believe that XYZ Inc., selling for $10 a share, is going to go down to $7 a share, I can ask my broker to find someone willing to let me sell their shares in XYZ at $10 a share. When the price goes down, I buy back the shares at $7 and return them to the person that originally owned them, pocketing the $3-per-share difference in price as my profit.
The short interest theory says that when large numbers of investors are short selling a stock, it will most likely increase in price, at least in the short term. The coming price increase, according to this theory, is created by investors who sold short, making purchases to cover their positions. The law of supply and demand responds to this sudden increase in demand for the stock by driving the price up.
Investors who utilize the short interest theory buy stocks that have a large number of short positions and then sell those stocks when the price moves up in response to an increase in demand.
The controversy surrounding this theory is that the decrease in a stock’s price is not always due to increased short interest in a stock, but because the company itself is not financially sound, in which case no amount of pressure will cause the price to increase. Similar to the greater fool theory, this strategy is based on limited knowledge and therefore subject to greater risk of failure.
Odd Lot Theory
Unlike the efficient market hypothesis, which says the collective knowledge of investors is always right, the odd lot theory says the collective wisdom of small investors is almost always wrong.
In its purest form, the odd lot theory is a completely technical style of investing that ignores a company’s fundamentals and makes decisions based on charts. The theory postulates that small-time investors — who usually buy and sell stocks in odd numbers of shares (odd lots) — either do not know, or are wrong about, a company’s fundamental financial strength or weakness.
The controversy with odd lot theory is that without an adequate understanding of a company’s fundamentals, the odd lot theory investors are simply buying blindly. Another criticism that travels hand in hand with the danger of buying blindly is that small investors are not wrong all of the time.
Finally, betting against small investors can backfire, because they are more nimble than large institutional investors and are able to react to bad news more quickly than their oversized institutional counterparts. Their selling may simply be a precursor to a larger selloff and even more significant decrease in share price.
It should go without saying that individual investors are not the same as large institutional investors, and yet failure to accept that fact is at the core of the popular copycat strategy of investing. This strategy is employed exclusively by individual investors who believe the trail to success is blazed by large investors.
Copycat investors will look at the portfolios of successful mutual funds or other very large investors and attempt to mimic them by purchasing the same stocks. The theory is sound, but the practice is not, because mutual funds and other institutional investors will own a much larger portfolio of companies than the individual investor can ever hope for. The result is the large investor benefits from diversification that the small investor can’t match.
Small investors often will seek to compensate for their inability to completely mirror the actions of large-scale investors by parroting what they believe to be only the most successful investment component. They mistakenly believe that will ensure them not only comparable returns, but superior results because they are cherry-picking only the top performers. Unfortunately, this can and often does result in catastrophic losses if one or more of the selected stocks suffers a downturn.