Two price points are crucial for any investor to be aware of: the present price for the asset they have or intend to acquire and the expected price at which it is sold. However, it is not uncommon for investors to constantly look back at their past price history and use this information to inform their investment choices in the future. Certain investors will not invest in an index or a stock that has increased too rapidly due to the belief that there's a chance for a correction. However, others avoid buying a declining stock due to the fear that the price will continue to fall.
Momentum
"Don't fight the tape." This well-known advice from the stock market warns investors not to get into the path of market trends. The idea is that the best bet for market fluctuations is to assume that they will continue to move in a similar direction. The idea is rooted in the field of behavioral finance. With numerous stocks to pick from, why would investors want to keep their capital in a company which is falling as opposed to one that's rising? This is a classic example of greed and fear.
Research has shown that the inflow of mutual funds is positively associated with market returns. Momentum is a factor in investing, and when more investors invest in the market, it increases and encourages more investors to purchase. This is a positive feedback loop.
A 1993 study conducted by Narasimhan Jegadeesh and Sheridan T. Titman suggests that stocks, in particular, have momentum. They discovered that stocks that have been performing well over the last couple of months have a higher chance keep their gains the following month. This is also true for the reverse stocks, which have had a poor performance and tend to repeat their disappointing performances.
Mean Reversion
The most experienced investors who have witnessed several market fluctuations generally believe that markets will eventually even out over time. The past has shown that high market prices can deter people from investing, but historically low prices could be an opportunity. A tendency for a factor like the price of a stock to reach an average over time is known as mean reversion. This phenomenon has been observed in various economic indicators, which are valuable to be aware of, such as exchange rates, gross domestic product growth, interest rates, and unemployment. A mean reversion can be a factor in business cycles.
Martingales
A martingale mathematical series that provides the most reliable prediction of the next number is the current one. This concept is utilized in the field of probability theory and is used to calculate the outcomes from random movement. For example, imagine that you have $50 and wager the entire amount on the coin toss. How much will you be left with after the toss? There is a possibility that you will have $100 or zero after tossing, but the most reliable prediction is $50, which is your initial starting point. Prediction of luck following the toss will be an inverse martingale.
In the case of stock option pricing, the market's returns can be interpreted as martingales. In this view, the value of the option is not based on the past price trend and any forecast of the future price trend. The current price and volatility estimate are the only inputs specific to stocks.
A martingale that is based on the assumption that the number following tends to have a higher probability of being greater than the previous one is called a sub-martingale. Popular literary literature describes this movement as a random walk with an upward drift. This description is consistent with over 80 years of market price time. Despite many short-term corrections, the general trend has always been upward.
Search for Value
Value investors purchase stocks at a discount and anticipate reaping the rewards with a higher price. They believe that an unreliable market has priced the stock and that the price will change as time passes. The question is, does this happen? And what is the reason why an inefficient market would adjust?
Research suggests that this reading and pricing mismatches are commonplace, but there is no evidence to explain their reasons. Value ratios tend to move in the opposite direction. However, research has not identified why the market keeps overvaluing these "value" stocks and then adjusting afterward. One conclusion that might be drawn from this is that these shares carry a higher risk that investors want more compensation in exchange for taking on more risk.
