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7 Wall Street theories

from Ken Zimmerman

Wall Street is about investing. To get a large return on money invested. There is no shortage of theories on what makes the markets tick or what a market movement means. Some of which influence investor decisions. The two largest factions on Wall Street are split between supporters of the efficient market theory and those who believe the market can be beaten. Although this is a fundamental split, many other theories attempt to explain and influence the market, as well as the actions of investors in the markets.

1. Efficient Market Hypothesis
Few people are neutral on the efficient market hypothesis (EMH). You either believe in it and adhere to passive, broad market investing strategies, or you detest it and focus on picking stocks based on growth potential, undervalued assets and so on. The EMH states that the market price for shares incorporates all the known information about that stock. This means that the stock is accurately valued until a future event changes that valuation. Because the future is uncertain, an adherent to EMH is far better off owning a wide swath of stocks and profiting from the general rise of the market. “Hedging one’s bets, so to speak.” Economists seem to like EMH. Mostly, it seems because it has little empirical support.

Opponents of EMH point to Warren Buffett and other investors who have consistently beaten the market by finding irrational prices within the overall market.

2. Fifty-Percent Principle 
The fifty-percent principle predicts that (before continuing) an observed trend will undergo a price correction of one-half to two-thirds of the change in price. This means that if a stock has been on an upward trend and gained 20%, it will fall back 10% before continuing its rise. This is an extreme example, as most times this rule is applied to the short-term trends on which technical analysts and traders buy and sell.

This correction is thought to be a natural part of the trend, as it’s usually caused by skittish investors taking profits early to avoid getting caught in a true reversal of the trend later. If the correction exceeds 50% of the change in price, it is considered a sign that the trend has failed, and the reversal has come prematurely.

3. Greater Fool Theory
The greater fool theory proposes that you can profit from investing if there is a greater fool than yourself to buy the investment at a higher price. This means that you could make money from an overpriced stock if someone else is willing to pay more to buy it from you.

Eventually, you run out of fools as the market for any investment overheats. Investing according to the greater fool theory means ignoring valuations, earnings reports, and all the other data. Ignoring data is as risky as paying too much attention to it, and so people ascribing to the greater fool theory could be left holding the short end of the stick after a market correction.

4. Odd Lot Theory
The odd lot theory uses the sale of odd lots – small blocks of stocks held by individual investors – as an indicator of when to buy into a stock. Investors following the odd lot theory buy in when small investors sell out. The main assumption is those small investors are usually wrong.

The odd lot theory is a contrarian strategy based off a very simple form of technical analysis – measuring odd lot sales. How successful an investor or trader following the theory depends heavily on whether he checks the fundamentals of companies that the theory points toward or simply buys blindly.

Small investors aren’t going to be right or wrong all the time; so, it’s important to distinguish odd lot sales that are occurring from a low-risk tolerance from odd lot sales that are due to bigger problems. Individual investors are more mobile than the big funds and thus can react to severe news faster, so odd lot sales can be a precursor to a wider sell-off in a failing stock instead of just a mistake on the part of small-time investors.

5. Prospect Theory
The prospect theory can also be known as the loss-aversion theory. Prospect theory maintains that people’s perceptions of gain and loss are skewed. That is, people are more afraid of a loss than they are encouraged by a gain. If people are given a choice of two different prospects, they will pick the one that they think has less chance of ending in a loss, rather than the one that offers the most gains.

For example, if you offer a person two investments, one that has returned 5% each year and one that has returned 12%, lost 2.5%, and returned 6% in the same years, the person is more likely to pick the 5% investment because they put an irrational amount of importance on the single loss, while ignoring the gains that are of a greater magnitude. In the above example, both alternatives produce the same net total return after three years.

Prospect theory is important for financial professionals and investors. Although the risk/reward trade-off gives a clear picture of the risk amount an investor must take on to achieve the desired returns, prospect theory tells us that very few people understand emotionally what they realize intellectually.

For financial professionals, the challenge is in matching a portfolio to the client’s risk profile, rather than reward desires. For the investor, the challenge is to overcome the disappointing predictions of prospect theory and become brave enough to get the returns you believe are possible.

6. Rational Expectations Theory
The rational expectations theory states that the players in an economy will act in a way that conforms to what can logically be expected in the future. That is, a person will invest, spend, etc. according to what they rationally believe will happen in the future. By doing so, that person creates a self-fulfilling prophecy that helps bring about the future event.

Although this theory has become quite important to economics, its utility is doubtful. For example, an investor thinks a stock is going to go up, and by buying it, this act causes the stock to go up. This same transaction can be framed outside of rational expectations theory. An investor notices that a stock is undervalued, buys it, and watches as other investors notice the same thing, thus pushing the price up to its proper market value. This highlights the main problem with rational expectations theory: It can be changed to explain everything, but it tells us nothing.

7. Short Interest Theory
Short interest theory assumes that high, short interest is the precursor to a rise in the stock’s price and, at first glance, appears to be unfounded. Common sense suggests that a stock with a high short interest – that is, a stock that many investors are short selling—is due for a correction.

The thinking goes that all those traders, thousands of professionals and individuals scrutinizing every scrap of market data, surely can’t be wrong. They may be right to an extent, but the stock price may rise by virtue of being heavily shorted. Short sellers must eventually cover their positions by buying the stock they’ve shorted. Consequently, the buying pressure created by the short sellers covering their positions will push the share price upward.

The Bottom Line
I’ve covered a wide range of theories, from technical trading theories like short interest and odd lot theory to economic theories like rational expectations and prospect theory. Every theory is an attempt to impose some type of consistency or frame to the millions of buy and sell decisions that make the market rise and fall daily.

While it is useful to know these theories, it is also important to remember that no unified theory can explain the financial world. During certain time periods, one theory seems to hold sway only to be toppled soon after. In the financial world, change and uncertainty are the only constants. In these circumstances the DSGE is useless.

https://rwer.wordpress.com/2019/11/18/why-wall-street-shorts-economists-and-their-dsge-models-2/

  1. Yoshinori Shiozawa
    November 22, 2019 at 10:16 pm

    Good job, Ken Zimmerman! This vividly conveys the mood of Wall Street, or better, theories in the brains of Wall Street traders and investors.

    Let me add one point each on (1) Efficient Market Hypothesis and (2) Rational Expectations Theory that are real theories in the mainstream economics (to which I am opposed).

    (1) Efficient Market Hypothesis (EMH)
    As Ken explains, one version of this hypothesis states that the market price for shares incorporates all the (publicly) known information about that stock (semi-strong version of EMH interpretation). However, this is quite ambiguous as a hypothesis to test. A testable version of EMH is that share prices are martingales, or in other terms, today’s price is equal to the expectation of future prices. This hypothesis can be checked by stock price time series and it is a difficult hypothesis to reject. So, EMH has a good empirical support. I wonder if there is any other hypothesis in economics that is as solid as EMH. Buffet an d others are only very scarce outliers.

    However, we should not be misguided by the name like Efficient Market Hypothesis. EMH does not tell that stock market is efficient in the ordinary means. Stock market is full of booms and collapses and yet EMH holds also in those situations. EMH only attests that stock market is informationally efficient but not economically efficient.

    (2) Rational Expectations Theory (RET)
    RET normally assumes an economic theory like the consensus macroeconomic model. It states that if a theory is accepted by all participants then people behave as the theory tells. (There is no logically expected future.) However, economists will be astonished if RET is applied to stock markets, because there is no established theory (probably other than EMH). If all players accept EMH, then all players are noise traders because “rational” player would only buy indexes ant would not buy individual stocks. In such situation, EMH holds well, because stock prices show a pure random walking.

    I want to ask Ken or other readers whether there exist researches done by DSGE model on a concrete stock market. There are some researches that intend to analyze the relations between stock market index and macroeconomic variables, but it seems to me that even mainstream economists do not think that DSGE model directly applies to a stock market. If my impression is correct, mainstream people may consider that Ken’s notes are irrelevant for their DSGE models.

  2. November 23, 2019 at 11:39 am

    Yes, Yoshinori, this is the sort of thing Ken is good at, though what Wall Street thinks is not my idea of economics. Regarding your emphasis on EMH, I would like to point out that Shannon’s book on “The Mathematical Theory of Communications” is not just about the efficiency of encoding but about the use of spare capacity to ensure reliability of its communication.

    What good is efficiency without reliability?

  3. Yoshinori Shiozawa
    November 24, 2019 at 2:28 am

    Yes, Dave, you are right. It is important to know the real significance of Efficient Market Hypothesis (EMH). It only means that stock market incorporates all information quickly. But, such a system, i.e. quoted market system, is fragile, unstable, unreliable, and often disastrous. What Ken is missing is that as a proposition EMH is an extremely solid hypothesis.

    Of course, what Wall Street thinks is not economics, but ti is the object of consideration. Economics of “financial economy” (or FIRE i.e. Finance, Insurance and Real Estate) is quite different from “real economy” (economy of production, distribution and consumption). I ordinarily work on real economy. But I am interested in financial economy, because it is “important”, not in the meaning that it has a great (moral, cultural or historical) value, but it has some vicious influences continuously.and sometimes disrupts normal working of real economy enormously (like the time of Lehman collapse). Economics of financial economy (different form financial economics) is extremely important field of economics but least developed. It must take into consideration even the wrong “theories” which drive the people in Wall Street. Ken has provided us some of such object of consideration.

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