Theories of the Stock Market 

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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 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, 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 Internet bubble.

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

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