As mentioned in the previous investment theory series, investors are either those who believe in the efficient market hypothesis and those who think they can beat the market. The second group often use fifty percent principle when planning out their investments.
What is the Fifty Percent Principle?
This principle is a technical correction that reverts at least 50% to 67% of a stock’s most recent price gain before appreciating once more. For instance, if a particular stock gained 35%, the principle calls that it will give back at least 17% of that gain before gaining some more.
Understanding the Principle
Following this principle is vital for investors as it will guide other charting techniques when monitoring a stock price’s rise and fall. The one-half retracement used in this principle is what most technical analysts check before the resumption of buying at the lower support levels.
The fifty percent principle is an investing strategy that takes into consideration the changes in the market more than the company’s underlying value. It purports that any observed trend will have a corresponding price correction at least one-half or two-thirds of the current price change.
This price correction is an intrinsic part of the trend, mostly caused by nervous investors who want to take in profits early on. Many of these worried investors sell their stocks before they get caught in the real price reversal later on. Note that corrections exceeding 50% may be a genuine reflection of a failure in the trend. This price fall means the reversal came prematurely. However, if the price drop is natural, it could be due to investors cashing in on their profits.
For example, XYZ Company gained 20% last year without any price corrections exceeding 10%. Looking at the trend shows a consistent upward trajectory. However, towards the top of the trend line, you notice that the price starts to go back below the 5% correction level. Based on the principle, the price will retrace at least 10% before resuming its upward trajectory. As a short-term investor, gains are secondary if you monitor these ebbs and flows. Timing your movement along with the market is crucial.
Herd Mentality and Fifty Percent Principle
An investor’s behaviour is mostly psychology-driven. Some aggressive investors who, by choice, place contrarian bets on the markets based on their charting observations. One notable example of this contrarian investing was evident in the Big Short of 2008 housing crisis. A few investors resisted the housing trend and received massive gains in just a few weeks by shorting the market.
In conclusion, fifty percent principle is beneficial for short-term investors. These investors monitor changes in the market regularly, so it will be easier for them to predict sudden changes. They reap the rewards because they have a deeper understanding of the several charting techniques available today. It is also noteworthy that these investors often make decisions based on the market. This much more important to them, more than the information they get about the company and its shares.