Long Term Winning Strategy For The Stock Market

Published Date: 02 Nov 2017

Introduction

If there is a long-term winning strategy for investing/ trading in the stock market, it means the market is efficient. Research on the stock price trend and its main influencing factors such as investor psychological behavior cannot only help the investors to understand the running mechanism of the stock market but also provide supervision institutions with related advice about their policies. The behavior finance study is the newest research in the financial study. It breaks through the traditional finance study viewpoint and studies investors’ behavior from the psychology angle. It is important to analyze the stock market from the angle of behavior finance study and discuss the investors’ behavior. Especially, the emerging theories such as behavior finance theory, which based on psychology and behavior theory, emphasis the influence of psycho on the investment decisions. This essay will firstly discuss the background of behavior finance. Following this, it will explain the disadvantages of Efficient Market Hypothesis to support the long-term winning strategy for investing/ trading in the stock market. Finally, it will use some theries to support the long-term winning strategy for investing/ trading in the stock market and go against Efficient Market Hypothesis.

The background of behavior finance

Behavioral finance is a science studying the decision-making behavior of investors under uncertain circumstances by using new mode about human nature. In 2002, The Nobel Prize of Economics was awarded to Daniel Kahneman, an American Psychologist, which means the Behavior Finance has been accepted by the mainstream of economics. Behavior finance is based on the suspicion of the hypothesis about rational prospect, risk evasion and maximum utility in the modern classical financial theory. Behavior finance began to develop in China in 1980's resulting from the discrepancies between traditional finance theory and practical application. Behavior Finance has been a hot academic theme in recent years. Behavior finance with tradition finance is an opposition to unify. Get into 1980's, the behavior finance learns along with the micro corpus studies of value increasingly in the financial circles quick development strengthens. The behavior finance mimics the financial affairs practice to enterprise or the company having very important significance.

By now, behavioral finance has had a predominant impact on many financial services. However, long-term investors in the stock market have received extremly little directions from behavioral financial economists.

The disadvantages of Efficient Market Hypothesis to support the long-term winning strategy for investing/ trading in the stock market

In 1965, Fama (professor from Chicago University) invented EMH (Efficient Market Hypothesis) theory. The Efficient Market Hypothesis is fundamentally a consequence of equilibrium in competitive markets with fully rational investors. To the extent that some investors are not rational, their trades are random and uncorrelated and therefore cancel each other out without affecting prices. To the extent that investors are irrational in similar ways, they are met by arbitrageurs who eliminate their influence on prices. It is debatable that investors are in fact fully rational. There are numerous such studies identifying challenges to weak form efficiency including the work by the arch protagonist of market efficiency Eugene Fama. In short, with the CRSP daily data back to 1962, recent research is able to show confidently that daily and weekly returns are predictable from past returns. The work thus rejects the old market efficiency constant expected returns model on a statistical basis. Efficient Market Hypothesis (EMH) has studied the relationship between stock price and information in stock market.

The disadvantages of Efficient Market Hypothesis：

First, Efficient Market Hypothesis exaggerates and deificates the spontaneous effect of market regulation. It denies inner contradictions and problems of market operation, and it rejects the positive role of government in the regulation of market operation. The investment in the stock market is usually at market bottoms. As a result, all of us question the wisdom of investing in the stock market for the long-term. Although Britain's richest are experiencing the sharpest surge in wealth, the rest of the population has also benefited from the stock market boomrising house prices. You should learn more about the stock market to have a better understanding of how the stock market works.

Second, Efficient Market Hypothesis cuts the inner link of the capital market operation and economic operation, and denies the effect of economic law. In modern times, because the stock market has the prospect of high returns together with low long-term risk, many investors like it. Many investors are trying to invest in the stock market for a long-term (Campbell, John Y., and Luis M. Viceira, 2001). If expected stock profits are unchangeable in the course of time, then similar to the high profits of the past, one can hope to earn high stock profits in the future; but in this case, investment in the stock market is a risk in the long-term, just as they are in the short term. If instead stocks tend to revert to the mean, then they are relatively safe assets for long-term investors (Campbell, John Y. and Luis M. Viceira., 2002); but in this case future returns are likely to be meagre as mean-reversion unwinds the spectacular stock market runup of the past decade.

Third, Efficient Market Hypothesis faces the challenge that the realistic contradiction movement and internal operation crisis from western capital market. Mathematically, if its expected profit varies over time, we can see the risk of an asset, which are different between the short-term risk and the long-term risk. With constant expected profits, the annualized standard deviation over a long holding period (say N years) is the standard deviation over one year divided by the square root of N. Thus with constant expected profits, the standard deviations of all assets would shrink with the square root of the horizon, but they would shrink together; we could not see the standard deviation of stock returns shrinking more rapidly than the standard deviations of the profits of bonds and bills. Evidence for reduced relative risk of stocks at long horizons is therefore indirect evidence for predictable variation in stock returns.

Use some theries to support the long-term winning strategy for investing/ trading in the stock market and go against Efficient Market Hypothesis

Investors and researchers have disputed the Efficient Market Hypothesis both empirically and theoretically. It is thought that the imperfections in financial markets are related to a combination of cognitive biases. For example, overconfidence, overreaction, representative bias, information bias, and various other predictable human errors in reasoning and information processing. These have been researched by Daniel Kahneman, Amos Tversky, Richard Thaler, and Paul Slovic and other psychologists. These errors in reasoning lead most investors to avoid value stocks and buy growth stocks at expensive prices, which allow those who reason correctly to profit from bargains in neglected value stocks and the overreacted selling of growth stocks.

Behavioral psychology approaches to stock market trading are among some of the more promising alternatives to EMH. However, Nobel Laureate co-founder of the programme, Daniel Kahneman announced his skepticism of investors beating the market. It is just not going to happen. Indeed defenders of EMH maintain that Behavioral Finance strengthens the case for EMH in that BF highlights biases in individuals and committees and not competitive markets. For example, one promiment finding in Behaviorial Finance is that individuals employ hyperbolic discounting. Transparently, it is true that bonds, mortgages, annuities and other similar financial instruments subject to competitive market forces do not. Any manifestation of hyperbolic discounting in the pricing of these obligations would invite arbitrage thereby quickly eliminating any vestige of individual biases. In the same way, diversification, derivative securities and other hedging strategies assuage if not eliminate potential mispricings from the severe risk-intolerance (loss aversion) of individuals underscored by behavioral finance. On the other hand, economists, behaviorial psychologists and mutual fund managers are drawn from the human population and are therefore subject to the biases that behavioralists showcase. By contrast, the price signals in markets are far less subject to individual biases highlighted by the Behavioral Finance programme. Richard Thaler has started a fund based on his research on cognitive biases. In a 2008 report, he identified complexity and herd behavior as central to the global financial crisis of 2008.

Further empirical work has highlighted the impact transaction costs have on the concept of market efficiency, with much evidence suggesting that any anomalies pertaining to market inefficiencies are the result of a cost benefit analysis made by those willing to incur the cost of acquiring the valuable information in order to trade on it. Additionally the concept of liquidity is a critical component to capturing "inefficiencies" in tests for abnormal returns. Any test of this proposition faces the joint hypothesis problem, where it is impossible to ever test for market efficiency, since to do so requires the use of a measuring stick against which abnormal returns are compared - one cannot know if the market is efficient if one does not know if a model correctly stipulates the required rate of return. Consequently, a situation arises where either the asset-pricing model is incorrect or the market is inefficient, but one has no way of knowing which the case is.

A key work on random walk was done in the late 1980s by Profs. Andrew Lo and Craig MacKinlay; they effectively argue that a random walk does not exist, nor ever has. Their paper took almost two years to be accepted by academia and in 2001 they published "A Non-random Walk Down Wall St." which explained the paper in layman's terms.

These days, talking about the stock market is a reliable way to communicate well with each other in our daily conversation. Nevertheless, at times, nearly everyone has lost faith in stocks and we should think about investment in the stock market carefully. Indeed, among the shares hardest hit the summer in 2008 were those that unscrupulous brokers had touted as sure-fire winners from the business: restaurants selling Peking duck, hotels, and so on.

However, it is not a time to get overly optimistic about anything. Most of us are in a challenging situation. Understandbly, compared with the risk of investing in the stock market, many people tend to keep their savings in the bank (Stucki, Barbara, 2006). If there is any guide in history, eventually, both the economy and the stock market will pull throw.

We can do as follows.

First of all, let's don't get greedy. Concentrate on blue-chip stocks, that is, companies that have a long and successful pedigree and decent long-term prospects.

Second, the balance sheet must be paid attention to. Those more suited to pull throw are companies with better cash positions.

Third, we should look at dividends. If the stock market keeps moving sideways, companies fitting the previous criteria should be able to maintain that payout, which is helpful.

As is representative in difficult times such as the financial crisis, each of these ideas may give you a logical warning that could stay your hand. In the stock market, there is never a thing without question, which is certificate of deposit. Moreover, usually you will not be given too much in return over the long-term.

The followings are four blue-chip names for you to consider. Avon Products, Microsoft, General Electric and Boeing are all famous companies.

Conclusion

In conclusion, firstly, the relatively large amount of money put into the stock market will lead to the frequent fluctuation of the stock price at a high level. Secondly, the relatively large amount of investors will also lead to the similar phenomena. Finally, passive investment attitudes have negative influence on the rising trend of the stock price. In a word, there is a long-term winning strategy for investing/ trading in the stock market, and it means the market is efficient.