Investment theories and maxims
Individuals have over millennia attempted to improve their wealth and this activity is an innate instinct of humankind. As we have seen, risk is forever inherent in investments, and rational humans endeavour to invest in a manner that maximizes return and minimizes risk. This desire had given rise to many theories related to investments and maxims (i.e. not quite theories) that revolve around particular investment styles and strategies.
Following is a list of some of the investment-related theories and maxims:
- Top-down investing (the big picture; emphasis on the economy and asset class allocation first and share analysis last).
- Bottom-up investing (share analysis first and de-emphasis of the big picture).
- Value versus growth investing (certain ratios indicate value and growth companies and the former outperform the latter).
- Buy-the-rumor and sell-the-fact (buy shares when positive rumors abound and sell them when the facts are known).
- Castle-in-the-air theory (similar to aforementioned and the opposite of firm foundation theory).
- Fundamental analysis (aka firm foundation theory) (emphasizes intrinsic value; similar to bottom-up investing); aka security-valution.
- Cybernetic analysis (mathematically based systems that allegedly predict share price movements).
- Technical analysis (price patterns of the past are detected that foreshadow future price patterns).
- Prospect (or loss-aversion) theory (investors view gains and losses differently and therefore base investment decisions on perceived gains rather than on perceived losses).
- Expectations / market segmentation theories (theories explaining the shape of the yield curve).
- Moral hazard theory (a person insulated from a risk behaves differently than s/he would have being exposed to the risk).
- Principal-agent problem (a special case of moral hazard).
- The 10% rule (do not hold more than 10% in any asset).
- Life-cycle consumption theory (personal financial planning consists of transferring consumption / saving across life-cycle / stages).
- Efficient market hypothesis.
- Markowitz modern portfolio theory.
- Capital asset pricing model.
- Behavioural finance theory.
Some of these theories and maxims deserve more attention. This is provided below. We will not discuss the life-cycle consumption (and saving) theory further, as the first main section of this text covered our version of this theory.
Efficient market hypothesis
The efficient market hypothesis (EMH) declares that financial markets are informational efficient and this means that investors cannot consistently achieve returns in excess of average market returns, because all investors have and act on the same information.
The EMH is largely ignored in modern investment theory, and its remaining practical usefulness lies therein that the participants in the market who act on new information and expected future information, including the speculators, all contribute to price discovery (EPD), and market liquidity (ML, which contributes to EPD). ML is important in that investors can buy or sell shares with ease, meaning with no or little effect on market prices.
However, price discovery does not mean efficient price discovery in the sense of prices being "correct". There are vast differences at time between value and market prices, as we shall see later. Mr Dave Foord44, of Foord Asset Management, has the following views on the EMH:
"...we do not believe they are efficient at pricing securities. For evidence of this, look how often the forward interest rate curve is wrong. Also, prices on some multi-billion dollar companies change by more than 5% in a day with little or no material news flow. That is greater than the annual return on US dollar cash in a single day!
"It's important to understand that individual market participants have different time horizons. Probably because of this, they have different valuations. Prices are set by the last seller and buyer. Often their motivations have nothing to do with valuation. In fact, the majority of trade is for speculative purposes and not for investment. Therefore the majority of trade does not take any account of the long-term value of the asset. Why then should the price set by the marginal buyer and seller be correct for all?"