Stock Market Theories

Successful investing depends on correct predictions about the movements of the market, both as a whole and in its component parts. There is no foolproof way to successfully predict market behavior, which is why there is still no consensus on market theories. However, an understanding of the different theories of the stock market still offers the best possibility of making an informed investment.

Company Fundamentals

This theory argues that the best way to make a decision about investing in the stock market is to do research on the company itself. Although there is no strict law of determination, this theory holds that a company that is successful in its operations will be worth investing in. Although indicators like profit do not directly determine stock price, they can be a good sign of which way the stock is going. This way of decision making assumes that although an unsound company, like Enron for example, can skyrocket in terms of stock price, this performance cannot be maintained. On the other hand, a solid company with an undervalued stock price will eventually be recognized by the investing public and as a result the stock price will rise.

Environment

This is a theory of investment that chooses to spend much less time analyzing the fundamental characteristics of any investment, in favor of looking at the investment climate in detail. This means looking at the broader economic and political environment. This mode of investment pays special attention to factors such as new legislation that will effect investment, or the implications of investing in a company that has just opened up operations in a different country. Investors who pay attention to the environment ask about information such as what the prospects might be for investment overseas if there was a recent election or how a war might change the economy.

Supply and Demand

This theory is based on the classical idea of supply and demand as it relates to the stock market. Essentially, this theory proposes that the price of any stock is not affected as much by the company's performance or the general political climate so much as by the interaction of supply and demand. There are a finite amount of stocks and investors. On any given day, there might be more people who want to invest than there are stocks available, or vice versa. In this way, the interaction between the offering of stocks and investment by the public determines whether the value goes down, in the case of excessive supply, or up, in the case of excessive demand.

Investor Psychology

This viewpoint challenges the traditional idea that investors are well informed, or moreover that they behave rationally. Psychological theories of investment chalk up market movements more to a complex interplay of psychological and social drives at play in each investor in the investing public in general. However, this theory does not discount any possibility for predicting market behavior. On the contrary, it simply says the market doesn't necessarily behave in a way that makes logical sense. This is the type of viewpoint that observes investors behaving with herd mentality. Stock prices can skyrocket or plummet with little prompting other than the perception that others are buying and selling.

About the Author

Linda Ray is an award-winning journalist with more than 20 years reporting experience. She's covered business for newspapers and magazines, including the "Greenville News," "Success Magazine" and "American City Business Journals." Ray holds a journalism degree and teaches writing, career development and an FDIC course called "Money Smart."

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