How to Invest?
There are two main schools of thought where stock market theory is concerned and the one you believe in will help determine which investment strategy to follow. The Random Walk Theory (RWT) coined by Malkiel expounds that stock prices rise and fall at random, not reflecting the true value of stock. Eugene Fama’s Efficient Market Theory (EMT) tells us that the true value of stock is very close its price because the stock price mirrors all publicly available information related to the stock.
Advocates of the EMT don’t bother finding ‘underpriced’ stocks because they believe the price reflects true value. EMT advocates often use a buy-and-hold strategy which has a good return rate only in the long term since dividends are a slow way of generating income. A buy-and-hold investor should concentrate on building up a diverse and efficient portfolio. Depending on how strictly you follow the EMT you can either sell and replace underperforming stock or ‘marry’ your security, never divorcing from it unless desperation hits and you need the money. Sometimes people that buy and hold are accused of being lazy investors and this has some truth to it. Buy-and-hold stocks are better suited for the more primitive investors and those that don’t dedicate much time to continuously research company growth and future returns. Besides building a diverse investment portfolio it is important when using this strategy, to look for competitive companies with good long-term growth records. All said and done, it would still be wise to keep an eye on the dividends you receive in case a stock swap needs to be made.
If you’re more inclined to believe in the RWT, you had better be a damned good opportunist to be successful with market timing strategies. Investors that analyse and watch market prices seek to outperform the buy-and-hold method by seeking underpriced stocks to buy and sell when they suddenly become overpriced. Disciples of RWT aren’t interested in long term goals because they believe their strategy is the key to quicker money even though Malkiel’s theory essentially states that it is impossible to outperform a randomly fluctuating market. In this school of thought, building any specific type of portfolio is far from important. Ironically Malkiel proposes the buy-and-hold strategy as the one to best maximize returns. Studies have found that in general, market timers only do as well as chance allows them and sometimes even worse. There are however, exceptions to this study.
More Facts
Whereas buy-and-hold investors watch for specific companies, market timers need to keep an eye out for market signals. Good recognition and interpretation of these signals obviously takes a bit of practice. Books on technical analysis will certainly help while newspapers will be full of signals, sometimes obvious but often hidden. The highest level of market timing in terms of return time and risk is day trading. Both huge percentage returns and percentage losses are equally probable. Day trading alone has many different techniques, some of which can be applied to market timing too.
The above two trains of thoughts are just references, and should be used as such. Modern research has shown that neither theory is exactly true. For instance in the very short-term, high frequency strategies are known to be profitable as done by some hedge funds such as Millenium. But this is only available to the most sophisticated traders. Many people do not agree with these theories and this is why companies like banc de binary and other options brokers have seem a lot of demand for their products in recent year. But very few players are profitable when it comes to trading options.