generic 10 Controversial Investing Theories
One thing there will never be a shortage of when it comes to Wall Street is controversial investing theories. It’s just plain human nature to want to get an edge when it comes to making investment gains, so it shouldn’t be surprising that there are countless systems, strategies or theories about how to outperform the market.
Of course, if there was one simple way to consistently outperform the market, it would be proven, and everyone would be doing it. But such a guaranteed winning formula could never truly exist because in the stock market, there must always be winners and losers; after all, investors can only buy winning stocks from those who are willing to sell their shares to them. Still, many controversial theories that claim to be “the way” to beat the market remain popular with investors. Here’s a look at some of the most well-known.
Last updated: April 15, 2021
Greater Fool Theory
The Greater Fool Theory relies on the supposition that there will always be someone “dumb enough” to buy your stock from you at a higher price. This theory abandons all traditional stock valuation methods, such as P/E, price-to-sales ratio, earnings growth, or other metrics and focuses solely on the idea that a hot stock will continue to generate buying interest from other investors. Like many controversial investing theories, this idea can actually work for a while in a hot market, but ultimately, someone is left holding the bag. Subscribing to this “investing” theory is not much more than gambling.
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Day-of-the-Week Investing
Under this theory, investors should only buy stocks on a particular day of the week because it statistically outperforms all others. There are a number of problems with this theory that make it controversial. For starters, none of the touts who support this theory seem to agree on which day of the week is actually best, which is the greatest argument for why this theory won’t work over the long run. Next, if there ever was a proven statistical anomaly that showed without question one day of the week was better to invest in, market participants would exploit it so fast that it would no longer work.
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Efficient Market Hypothesis
The efficient market hypothesis is probably one of the best-known investing theories, but its conclusions remain controversial. Under this theory, since all available information about stocks is publicly known, it is already priced in. This means that there is no chance to buy a stock below its fair value because all stocks are already trading at fair value. The efficient market hypothesis persists because many academics actually support the concept, and it’s a cornerstone of Modern Portfolio Theory. However, the efficient market hypothesis seems to collapse when famous investors like Warren Buffett can continue to outperform the market over time. While certainly many if not most portfolio managers and individual investors do underperform the market, others do outperform, which is impossible under the efficient market hypothesis. Buffett himself downplays the concept of the efficient market hypothesis, saying, “Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace…”
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Odd Lot Theory
The Odd Lot Theory has lost some of its support in an era in which fractional share investing is possible, but it still maintains its adherents. Under this theory, which is contrarian in nature, when there’s an increase in small-lot selling in a stock, it’s time to buy. The belief is that small investors are usually wrong with their market calls, and small investors are usually the ones that buy and sell odd lots, or lots of less than 100 shares per trade. Thus, if small investors are selling out of a stock, it means it is time to buy. The reality is that there are any number of reasons that small lots are being sold in a stock, and it may well indicate additional selling pressure is yet to come.
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Loss Aversion Theory
Loss Aversion Theory, also dubbed Prospect Theory, suggests that human nature makes investors avoid losses more than they seek out gains. Under this theory, most investors would rather choose an investment that provides a small, consistent gain rather than one that fluctuates wildly. While this theory touches on the psychological truth as to how investors process gains and losses, actual market activity seems to disprove this concept. Take the 740% gain in Tesla shares in 2020 or the wild gyrations of GameStop stock in 2021 as examples. Clearly, investors in these stocks were not nearly as concerned about avoiding losses as they were about generating outsized gains.
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Seasonal Investing
The Seasonal Investing Theory promotes the idea that investing at certain times during the year is a way to outperform the market. This theory is perhaps best epitomized by the popular Wall Street saying, “Sell in May and go away.” As with many theories, part of this idea is rooted in reality. Over the summer months, many market participants are away on vacation, thus drying up liquidity and putting a lid on major moves in the market over that season. Even more compelling, statistical averages do indeed show that the November to April period outperforms May to October on average. However, while the theory may work in some years, it’s equally ineffective in others, making it an unreliable method to base an entire investment strategy on.
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Rational Expectations Theory
The Rational Expectations Theory sounds good in concept, but its value as a predictive mechanism is questionable. According to this theory, every investor will act according to what they believe will logically happen in the future. In so doing, they actually bring about the result they were expecting. For example, if an investor believes a stock will rise in the future, he or she will buy shares in order to profit from that rise. Physically buying the shares actually does help push the stock up and potentially entice other investors to buy as well, creating further gains. Part of the problem with this theory is that for every investor who “rationally believes” a stock will go up, there are others that believe the opposite. The Rational Expectations Theory simply doesn’t have enough real-world connection to validate its suppositions.
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Short Interest Theory
Short Interest Theory is one of the investing concepts that actually has some real-world merit. However, the long-term predictive value of the theory is not compelling enough for most investors to earn outsized profits from it. The theory suggests that investors should buy stocks with large short interest, or those which a large number of investors have bet against by borrowing and selling company shares. At times, the theory can work. After all, if a stock has a high short interest, it means that those short investors must at some point cover their shorts by buying back shares. Oftentimes, this buying comes in a flurry as all of the shorts try to cover at once, driving share prices up dramatically. However, after all of the short investors cover, the stock may trade down once again. Thus, the only way to really profit from this investing theory is to buy in right before the short investors cover, which can be tricky even for professional investors, let alone amateurs.
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50% Principle
The 50% Principle is a theory based on technical analysis, in which chart patterns and stock price movements are analyzed rather than the financial fundamentals of a company. The 50% principle suggests that a stock will retrace 50% of its most recent gains when it sells off before reversing once again and resuming its upward climb. This principle can be of some value to short-term traders, as it becomes something of a self-fulfilling prophecy when technical analysts base their trading around the concept. However, it falls apart as a long-term investment principle, as it doesn’t take into account exogenous factors such as economic recessions, corporate bankruptcies or other fundamental, economic factors that can affect the share price.
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Random Walk Theory
The Random Walk Theory is another famous investing theory, popularized by the successful book “A Random Walk Down Wall Street.” Closely allied with the efficient market theory, the random walk theory suggests that the movement of stock prices is totally random. In this scenario, investors have no hope of outperforming the market, because the movement of stock prices is totally unpredictable. The book famously suggests that a group of monkeys throwing darts at a board has just as much chance of outperforming the market as an investor who analyzes market data.
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