Theories of the Stock Market
Investment Snapshot: How Easy Is It to Beat the Market?
You undoubtedly have heard many conversations in which
investors have spoken about earning exorbitant returns from
the stock market. “I bought eBay or Amazon.com at issue and
made a 600 percent return in a short period of time,” or “I
missed buying Yahoo!, but I bought some other Internet stock,
which doubled in value within hours after purchase.”
Conversations such as these were prevalent during the
“Internet bubble” of the bull market in 2000. The type of business
the Internet companies were in or whether they ever
would be profitable didn’t matter. In fact, many Internet companies
never managed to earn any profits during their short
lifetimes. One of the few Internet companies that is still around
today, Amazon.com increased its sales year over year but only
years later was able to chalk up operating profits. Investors
with no financial acumen invested in these newly issued stocks
and were able to “beat” the returns of the market, which were
weighed down by stocks that were profitable but did not have
meteoric price rises.
With your investment knowledge to date you are correct if
you are asking, “How is this possible?” You are especially astute
if your thoughts are that the returns earned by these novice
investors were not sustainable over extended periods of time.
Similarly, you might question the aspect of risk in investing
in high-flying companies based on ideas with questionable
business models. Is it wise to invest large sums of money in a
company whose future viability is uncertain?
These queries are all valid. Yes, some lay investors did
beat the market averages during the Internet bubble, but did
they continue to outperform the markets in the period after
the downturn of Internet stocks? Probably not, or else their
names would be in lights, and they would be hailed as the
new investment gurus. Should you compare risky startup venture
companies with the established companies held in the
Dow Jones Industrial Average, for example? No, that would
be equating the Wal-Marts and Coca-Colas of the world with
the Globe.coms, which were in business briefly during the
This chapter focuses on the theories behind the rise and fall of stock
prices and whether investors can “beat” the stock market on a riskadjusted
basis over extended periods. The preceding two chapters
outlined how stocks are chosen using fundamental and technical
analysis. Fundamentalists are interested in what stocks are worth,
whereas technicians look only at historical prices and volume
records. A fundamentalist looks for stocks that are valued below
their intrinsic value and is not concerned with the reactions of
the crowds of investors, like technicians. This chapter explores the
different theories behind stock prices and examines, in greater
detail, the fundamental and technical approaches to buying stocks
with regard to earning higher risk-adjusted returns than the market.
The trader’s lament:
Buy and you’ll be sorry.
Sell and you’ll regret.
Hold and you’ll worry.
Do nothing and you’ll fret.
Many investors believe that they can successfully “time the
markets” by buying stocks when the markets are moving up and
then selling their stocks before the markets start to decline from
their peaks. Many investment advisory newsletters are aimed at
these investors, who are known as market timers. These newsletters
advise their readers when to buy and when to sell their stocks.
Correctly anticipating a correction or a crash certainly can
improve your rate of return. For instance, some newsletters correctly
advised their readers to sell their stocks before the stock market
crash in 1987 and to buy stocks after the Dow Jones Industrial
Average (DJIA) had fallen to its low of the year. Following this type
of strategy would have increased your returns over those who had
stayed invested during and after the market crash. However, the
trouble with market timing is that if you exit the market at the wrong
time, you miss out on stock market gains and it greatly reduces
your rate of return. History has shown that over extended periods,
investors who stay fully invested in the stock market reduce their
risk of mistiming the market.
Categories in Trading Mistakes
Lack of Trading Plan
Planning plays a key role in the success or failure of any endeavor
Using too much Leverage
Determining the proper capital requirements for trading is a difficult task
Failure to control Risk
Refusing to employ effective risk control measures can ensure your long-term failure
Lack of Discipline
A lack of discipline can destroy even the most talented and best prepared trader
Useful Advices to Beginning Trader
You can control your success or failure
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