How do the stock markets work

If human beings were to always behave rationally and logically then both stock prices and their future movements would be totally predictable. Share prices, in such a situation, would generally hover closely around their intrinsic values and opportunities for making money by buying tinder priced shares and selling them when they become over priced would virtually disappear. The fact that this does not happen is ample evidence that human beings do not act rationally and logically all the time.

We are all part of a crowd

A crowd is a collection of people gathered in one place, Stock market investors and speculators may not be present in one place physically but mentally they are all linked together in the same way as is an actual crowd. They read the same newspapers, they deal with the same group of stockbrokers, they watch the same share price movements, and they tend to react to news and events in the same manner. For all practical purposes, therefore, the. market is a crowd, and stock market behaviour can best be understood and interpreted if viewed as crowd behaviour.

Crowd behaviour is very different from the behaviour of individuals who make up the crowd, A crowd never reasons or thinks it is always swayed by emotions. Emotions being extremely contagious sweep through the crowd sometimes propelling it in one direction, at other times in another. This is the reason why crowds are never moderate in their approach they are always given to extremes of behavior. They also over react, pushing share prices up to unrealistically high levels or stamping them down to very low levels. Over reaction is a universal phenomenon exhibited by stock markets all over the world. Shrewd and knowledgeable investors make money by taking advantage of the fact that share prices always over react they pick up grossly under priced shares and sell them when they become grossly over priced.

In order to do so, however, you should be able to insulate yourself from the contagion of the crowd. Don't be drawn into the crowd stay outside it. This is easier said than done, of course. But if you wish to be a successful investor you will have to learn to keep your head when everyone else seems to be losing theirs. Study crowd behavior, watch the crowd in action, anticipate and predict its movements but don't become a part of it. People belonging to the crowd never make much money; they only provide an opportunity for others to do so.

Admit your mistakes

Most human beings find it very difficult to admit their mistakes. They usually rationalize and invent reasons for justifying their actions and assessments, put the blame on somebody else, ascribe their misfortunes to ill luck or fate in fact, do everything but admit that they have been wrong. Failure to admit one's mistakes can be disastrous in the stock markets.

Unless you admit your mistakes, you will not know when and where to cut your losses. There is nothing unusual about making a mistake. Everybody makes mistakes, particularly when buying and selling shares. Even the most successful stock market operators readily admit that they make mistakes quite frequently. There is an oft quoted stock market maxim: "Every time a share is bought or sold, somebody somewhere has made a mistake." Therefore, don't be ashamed to admit your mistakes. The quicker you are in admitting your mistakes, the easier you will find it to pull out of bad investments in time.

Greed and fear

Greed and fear are the two most dominant emotions found in the stock markets. They are the two extreme aspects of crowd behavior. Greed is the most prevalent emotion in a rising market; fear takes over in a falling one. Greed causes frantic buying whereas fear causes panic selling. It is because of greed and fear that the markets always over react in booms and depressions. If it were not for greed and fear, share prices would not fluctuate as violently and as erratically as they actually do.

Whenever you find that you have achieved or crossed your investment objectives, you should sell. Don't be greedy and hold on to your shares in the expectation of further gains. An overbought market is highly unstable and may collapse at any moment. On the other hand, don't panic into selling after a steep fall in share prices. Remember, that recessions and slumps are temporary phenomena sooner or later they are bound to give way to a rising market, If you hold on, you will find that the subsequent rise in prices is likely to compensate you amply for the waiting period.

Don't be a snob

Snobbery is as prevalent in the stock markets as in other areas of life, There are many investors who buy shares not because of their intrinsic worth, but because of their snob value. Even their investment selections are dictated by the snob value of various scrip. Shares of companies having impressive, foreign sounding names and marketing products with prestigious brand names and clientele are preferred for investment as compared to companies belonging to newly formed Indian business houses. Avoid being a snob, Snobbery doesn't pay in the stock market. Foreign sounding names are not necessarily gateways to wealth and riches. You "rill do well to base your investment decisions on things more solid and realistic than mere snobbery!

Seeing the reality for what it is

Many of us view the stock market with preconceived notions and ideas. We think that the market actually is what we think it ought to be. Most of us make the mistake of substituting reality with wishful thinking. The market is not concerned with what you think it ought to be. It is what it is. If you wish to be successful, you will have to learn to view it as it is, and not as what you would have it to be.

Don't get influenced by your own concept of an ideal market while making your buying and selling decisions. Don't let preconceptions and wishful thinking influence you be objective and realistic in your approach to investment matters.

Keeping up with your neighbours

Many people buy shares in a particular company simply because all their friends and colleagues seem to have shares in it. They do so because they don't want to be left out. Don't buy shares in a company simply to keep up with the Joneses. There is no reason to presume that your neighbours and colleagues have better in. vestment knowledge and judgement than you. In fact, keeping up with the Joneses is one of the ways in which you get sucked into the crowd. As we have seen earlier, being part of a crowd is not likely to get you anywhere. You must always retain your objectivity and independence of judgement while taking investment decisions.

Learn to take risks

When you decide to buy shares you are knowingly and willingly exposing yourself to a variety of risks. The shares you buy may not appreciate in value or, worse, their price may actually plummet, leaving you with a capital loss. The company whose shares you buy may not perform as well as you expect, or even if its performance were to live up to your most optimistic expectations the market may not be sufficiently enthused over it to push up its share price. Moral: don't buy shares unless you are emotionally and temperamentally prepared to take some risks.

Once you decide to enter the stock market, then don't let the possibility of making losses prevent you from taking reasonable and calculated risks. The higher the risk, the greater the potential rewards, Low risks invariably imply low returns. Therefore, don't play safe. Learn to take risks. If you don't risk your capital, you will be depriving yourself of the only realistic chance you will ever have of becoming rich. Remember, the economic structure of the world is rigged in favour of the bold risk taker.

How do you know that you are taking sufficient risks? The first Sign after you have made a risky investment will be a feeling of unease and anxiety. If any investment gives you a feeling of smug satisfaction, then it means that you have not taken the required degree of risk necessary to earn big profits. The best investments are those that make you toss and turn in your bed at night and not those that give you sound, carefree sleep. Remember, as an investor your main goal is making money and not sound sleep. As the Swiss say, a "state of worry" is the price you pay for the opportunity of making money.