Understanding the Stock Market

The stock market is a place where you can actually buy shares in a company. The value of those shares will go up or down depending on how well the company is doing, as well as other factors that I will speak to later. If the value of the shares goes up, you can sell them at a profit. If they go down, you can hold them hoping they will go up again or give up on them and take a loss by selling them.

Since you are buying a piece of a company, you have certain rights. At annual meetings you can vote for officers as well as vote on other business at hand. If you cannot attend the meeting, you can vote a proxy and let your wishes be known. Some shareholders are becoming more active in the companies in which they hold shares, seeking to influence CEO salaries and other company policies.

Investing in the stock market is a bit like gambling. Certainly there are no “sure things.” Various experts have their preferred ways of determining whether a stock is a good buy or not. Stocks are called overvalued if the price is too high in relation to the fundamentals of a company. Conversely, they are undervalued if the price of the stock is lower than the company’s success would suggest.

Big time investors use charts to see how individual stocks are doing over time. There are many arcane numbers that fill these charts, like 50 or 200-day moving averages. One of the biggest names in the investing business, Warren Buffet, does what he calls value investing. Essentially, he buys sound businesses with good leadership which he believes will increase in value over time. He is a buy and hold kind of guy. He is also the second richest man in America.

In spite of all of the charts and systems of investing, investing in the stock market is not a strictly mathematical game. Knowing all of the facts about a company may not be enough to be successful. That is because investing in the stock market is run as much by emotion and rumor as it is by fundamentals. Comments from Ben Bernanke can move the market up or down almost instantaneously.

The old pros say that those who invest in the stock market move between fear and greed. When you become fearful, you sell. When you become greedy (or euphoric), you buy. The problem with this emotional process is that you may be greedy when you should be fearful and vice-versa.

There is a group of investors, a small but diverse group, who call themselves Contrarians. The Contrarians try to put fear and greed on their heads. When the mob is selling out of fear, the Contrarians are buying. When the mob is buying out of greed or euphoria, the Contrarians are selling. Why is that, and how does it give them an advantage?

There are many classes of investors, but at the extremes are the institutional investors, the mutual fund buyers, insurance companies, and other large businesses who invest for profit. At the other extreme are the mom & pop investors. In between are many individuals who essentially make a living investing and/or writing newsletters about investing. Among these would be the TV pundits whose opinions and prognostications are widely sought in the mainstream media.

The Contrarian philosophy focuses on the movement of emotion in investing, not just the movement of the stock price. They will definitely pay attention to a company’s fundamentals and they may look at charts of moving averages and other indicators. But they focus on the large movements of a stock or even of the entire market to help them time when to buy and when to sell.

It’s really pretty simple. When a company is new or small and unknown, the Contrarian is interested. If the company has all of those things that Buffet looks for, and the company seems undervalued, they may buy into that company. They will buy when the price is low and few others are buying. This is the beginning phase.

If the company is sound and the stock goes up, it will gradually come to the attention of institutional buyers, fund buyers, and other large buyers. The stock will go up more. After the institutional buyers, a phase three kicks in. The company now is showing growth and the price is rising. Now it may come to the attention of the public. This is a company on the move!

The mob now goes into greed or euphoria mode and John Q. Public starts buying the stock. Now it really goes up. But now it is approaching an overbought status. The price of the stock is higher than the fundamentals would indicate. This is when the Contrarians sell. The stock will stop its upward trajectory because it is overvalued and because the contrarians are selling. The last folks in, the mob, are going to get burned.

The stock market is a big financial playground but the games played there can get rough. Emotional buying and selling can be dangerous. The old advice still holds. Don’t invest more than you can afford to lose.