Wall Street is not rocket science—it’s just a big bazaar where people haggle over trinkets. In a bazaar, the seller and the buyer haggle over the price of say, a carpet. The seller wants to get more for the carpet, and the buyer wants to pay less. The price is fluid for as long as they haggle, but at one point, they may find a price they agree on, and the goods will then change hands. Whoever haggled better than the other is likely to have walked away with greater value.
The stock exchange is no different than the bazaar. The main difference is that as an investor, you are not haggling with a seller directly—but with your own willpower.
Your primary obstacle is not “the market”—which is just a collection of investors like you—but yourself. Why? Because no one is forcing you to buy or sell anything. You are doing it of your own accord—and your actions should be, as in all other realms in your life, mostly under your control. But there are forces that affect when and what you do, which as we all know, in the stock market, can make all the difference.
All this can create lots of problems if you do not have crystal-clear insight into the forces that influence your actions. Whenever the mind’s main opponent is the mind itself, it helps to have a psychologist on hand.
I have come to believe that the market is 10% business and 90% psychology. The reason is simple. Although stock prices should be anchored by the success and earnings of a company, they often stray away in either direction. Business—the part where people work and produce and sell goods and services—can’t possibly change so fast. Yet prices often change from second to second, sometimes drastically—with speeds that are more common in the realms of mind and emotion.
Price is a measure of behavior: a quick demonstration
One day, in the process of making a trade on a slow-moving stock that I happen to own in two different accounts, I saw how my own psychology didn’t just nudge the price of the stock for everyone—but determined the value in every shareholder’s portfolio. I admit I was a little grumpy with this glacial European liquor stock, which I’d held for some time. I wanted to offload it only at a profit for all my trouble, so I put a rather whimsical odd-numbered limit order, higher than the going price, with a take-it-or-leave-it attitude. In a limited sale order, the transaction goes through only if the buyer accepts that exact price or higher. Because it was a low-volume foreign company stock, soon I saw my exact order price with my exact number of shares posted as the official “ask” price on my—and every trader’s—screen. When a buyer out there finally took the bait and bought my shares, it was my whimsical price that flashed in big bold letters as "the" current price—and therefore the official current value—of the stock. This slow-motion transaction is a nice demonstration of how the current price is determined by the last completed transaction, i.e., the last price that moved a seller to sell and a buyer to buy, both of which are behaviors.
What was even more enlightening is that because I happened to still own a good number of shares of the same stock in a second account, my remaining shares—and my entire portfolio—had suddenly gained in real dollar value, because now the new price per share was based on that last transaction, which just so happened to be mine. Like me, millions of people who owned that stock saw their portfolio go up in that moment because my grumpy take-it-or-leave-it mood that moment set a price that a buyer welcomed with their own, more optimistic mood about the stock. It’s possible that the buyer knew something I didn’t about the prospects of the company and/or stock. Or, more likely, the buyer was just in a better mood after enjoying a few great cocktails made with the same liquor while sitting at a European café.
This one little slow-motion transaction—with global consequences—showed me how all prices are more psychology than business. Try it yourself, by selling a stock that trades within a narrow price range and with low volume—while keeping some shares to see the effect of your own transaction on the price of your own remaining shares. This can be a useful exercise to remember when prices are in free-fall during a particularly bad day on Wall Street.
The interpersonal nature of price
If the current price of a stock is simply the dollar value that the last two people agreed on for their transaction, then by definition, the dollar value of millions of shareholders’ portfolios is determined at any given moment by at minimum the last two people trading with each other—and at most two people for every stock owned in the portfolio. If my portfolio consists of ten stocks, then at any given moment, the mood and outlook and anxiety of exactly twenty people will determine the dollar value of my investment account. In the next second, the dollar value of my portfolio will be determined by twenty other people. Tomorrow, it will be twenty new people—and perhaps some of the same ones, if they are frequent traders.
Meanwhile, none of these buyers and sellers have anything to do with the products and services represented in the portfolio. In the case of European liquor, for instance, the recipe and production have remained the same. Its consumer fan base hasn’t changed much in 24 hours—and even the number of bottles sitting in stores and bars and hotels couldn’t have changed significantly. The only thing that changed in 24 hours is how all these people trading the stock felt about the prospects of the stock going up or down. They may not even have formed any new opinions about the financial prospects of the company itself—just how they felt about its stock price.
It’s important to use the word feel, because there may not have even been any new data or even news about the company or product to “rethink” its value in any way. In other words, the price could conceivably change with pure emotion. Yet, in 24 hours, the net of all those people’s feelings about the liquor changed the value by millions of dollars for millions of shareholders. This is the same exact process in action during rallies and corrections—the only difference there is that prices change by bigger extremes and usually involve many companies in many industries.
Stock price is essentially a case of behavior begetting behavior
The psychological and behavioral forces that apply to stock price are also at work in determining the 52-week high for any given stock. This relative peak price appears on every ticket and is often consulted by buyers to see how high the stock has gone recently and what it might be capable of in the near future. So remember that this anchor is just as subjective and based on completed—and at times whimsical—transactions.
Price is flighty simply because it is more tied to psychology, mood, sentiment, whatever you want to call it. But what originates in the mind has real-life consequences, of course. For one, what originates in one person’s mind can affect others’ perceptions and, as a consequence, their actions and their bank accounts too.
If investors collect information about the economy, companies, stocks, and price patterns, but don’t bother learning about how their own perceptions and emotions fit into the greater marketplace, they will be less in control over their own actions. The only thing investors have control over is their own behavior. The more disciplined traders earn the greater profits—generously financed by the less disciplined ones. That must be the other reason they call it finance. Investors decide to finance companies. But they unwittingly also finance each other.
The psychology of a correction
Ideally, when investors decide to realize gains, they sell what they planned to sell when the market is high. But it doesn’t always happen this way, especially for inexperienced or nervous investors. Although market corrections often appear to be triggered by negative news, they are mass psychological events that are heavily dependent on price psychology.
The psychological seeds of a correction are already present in the previous rally
A “correction” is the euphemism Wall Street likes to use for a stock selloff. With more sellers than buyers, stock prices take a dive. Sometimes it’s a short-lived blip when more optimistic investors come out and buy on the dip. Sometimes it’s a plunge into a deep abyss, as investors wait for even better deals—or for prices to stabilize—before buying in again.
The negative economic or geopolitical news only acts as an inciting incident, an event that is perceived and felt by millions of investors all at once. But not all investors will react in the same way. Long-term investors and institutional investors often sit tight during these dips. Similarly, investors who had purchased the stocks at a very low price may also stay the course. But those who purchased the stock at an already high price—such as those who bought it at the peak during the most recent rally—will invariably regret their purchase, and many will try to offload it, even if at a small loss. If half of those who bought Stock X at $1000, turn around and sell it when it dips to $900, then the price of Stock X will go down further, to say $800 because there are more sellers (supply) than buyers (demand). Now, half of those who bought it for $900 may be motivated to sell it, reducing the stock price further to $700, thus rattling a new class of high-priced buyers.
What’s the solution for the retail investor? Don’t buy a stock at its peak prices. Learn to buy stocks at their low points, when they are on sale. This is very different from buying a devalued stock when the company is going downhill, such as after missing earnings several quarters in a row. Naturally, you must do your research to make sure you are buying valuable companies at a lower price than they were before. If you buy like a submarine, price fluctuations will remain like waves on the surface, and feel “superficial” in that they have less effect on your portfolio—and by extension, your mood and behavior. In this manner, you don’t sell reactively, but you sell because it makes complete financial sense to do so. It takes discipline, but buying low is easier psychologically—and better financially. Because the value of hard cash is flat (in the short term), holding cash is easier psychologically than holding a sinking stock while you quickly decide to keep it or sell it. So take advantage of the greater psychological control that some cash on hand gives you, by being more discerning when to buy. Buy extra-low, either when there is a dip in a sector or the market at large—or because a particular valuable company is suffering from a short-term lack of love. Yes, price is also a measure of love.