4 Prominent Ways of Investment Forecast
If you are planning to make investments, you should understand two types of prices, viz. the ‘current price’ of your investment and its ‘future selling price’. Investors are commonly seen analyzing the history of past prices and using it to take their future investment decisions. Stocks risen too sharply are not bought by some investors as they believe that they may need a rectification, while falling stocks are avoided by some other investors as they are afraid that they will go on declining.
Are these kinds of predictions supported by academic evidence, on the basis of recent pricing? Here are four different perspectives of the market and more knowledge about related academic research that backs each perspective. You can better understand the functioning of the market from the conclusions and probably some of your biases may be eliminated.
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“Don’t fight the tape” is a widely used adage in the stock market world which warns investors not to meddle with the market trends. Here the advice is to move in the same direction as that of the market movements. This rule has been originated from the behavioral finance. When there are so many stocks to select from, why would investors invest their money in a stock that’s declining, instead of one that’s rising? It’s the typical greed and fear.
Research has observed that mutual fund influxes are positively related to market returns. The decision to invest is highly affected by momentum and if more number of people invest, the market rises, encouraging even more people to buy. This is a positive feedback loop.
One of the great ways to find and latch on trends is momentum indicator. However, several other technical indicators also exist that traders should consider using.
Sheridan Titman and Narasimhan Jagdish in their 1993 study “Returns to Buying Winners and Selling Losers” state that individual stocks have momentum. They observed that stocks that performed well in the last few months have higher chances to continue their outperformance in coming month. The inverse is also true: stocks that showed poor performance have higher chances to continue poor performance.
But this study looked ahead only one month. If longer periods are considered, the momentum effect is even found to reverse. Another study by Richard Thaler and Werner DeBondt named “Does the Stock Market Overreact?” in 1985 states that stocks that perform well in the last 3 to 5 years have higher chances to underperform in the next 3 to 5 years and vice versa. This shows that there is something else playing its role too, which is called mean reversion.
2. Mean Reversion
Seasoned investors, who have undergone many ups and downs in the market, usually have the perspective that the market will smooth out, over time. History says that these investors are usually discouraged from investing by high market prices, while low prices may indicate an opportunity.
The trend of a variable, like a stock price, to unite on an average price over time is known as mean reversion. The occurrence has been found in many economic indicators, including gross domestic product (GDP) growth, exchange rates, unemployment and interest rates. Mean reversion may even cause business cycles.
The jury is yet out regarding whether stock prices revert to the mean. A few studies reveal mean reversion in certain data sets over some time, but several others don’t.
Since at least 80 years of stock market history is accessible by the academia, it suggests that if the market does tend to mean revert, the phenomenon happens gradually and almost subtly, over several years or even decades. This is important for stock forecast.
3. The Search for Value
Value investors buy stock for low prices and hope to profit later. They expect that an inefficient market has reduced the value of stock, but the value will adjust over time. The concern is that whether this happens and why an inefficient market would make such an adjustment.
Studies suggest that this wrong pricing and readjustment happens constantly, though it shows a very little proof of why it happens.
Ken French and Gene Fama analyzed decades of history of stock market in 1964 and designed the three-factor model that explains stock market prices. The most important factor in describing future price returns was valuation, as calculated by the price-to-book (P/B) ratio. Stocks having low P/B ratios delivered significantly better returns than other stocks.
Valuation ratios are inclined to move in the same direction, and in 1977 similar results for stocks having low price-earnings (P/E) ratios were found by Sanjoy Basu. And since then the same effect has occurred in several other studies throughout dozens of markets.
However, there is no explanation of why the market is constantly mispricing these “value” stocks and adjusting later. It can only be concluded that these stocks have additional risk, for which investors ask for extra compensation.
Valuation ratios are driven by prices. Hence, the findings do support the concept of a mean-reverting stock market. As prices rise, the valuation ratios become higher too and therefore, future predicted returns are lower. Nevertheless, the market P/E ratio has changed widely over time and hasn’t ever been a consistent buy or sell signal.
No solid answers have been found even after decades of research by the most intelligent minds in finance. We can draw only a conclusion that there may be some momentum effects in the short term and a weak mean-reversion effect in the long term.
The main component of valuation ratios like P/B and P/E is the current price. These ratios have been seen to have some predictive power on the future returns of a stock, e.g. Netflix stock forecast. Nevertheless these ratios must not be considered as particular buy and sell signals, but as factors playing a role in increasing or decreasing the expected long-term return.
One more possibility is also considered that past returns are just unimportant. This was projected by the 1965 study by Paul Samuelson in which it was found that previous pricing trends had no effect on future prices and the study reasoned that there should be no such effect in an efficient market. The conclusion of this study was that market prices are martingales.
Consider all these factors while entering the investment market so that you can get maximum profit based on thorough research and study.