The stock market can do a lot of things efficiently. It can digest news about a company’s performance in seconds, for instance.
But it also picks up on the fear or greed of traders. If traders think a company is going bankrupt, they won’t wait to sell, and shares may end up going bankrupt as a result of a self-fulfilling prophecy.
Likewise, a lot of high-tech companies that went public in 2019 fizzled after their IPO as more investors were able to weigh in on their high valuation relative to the money (if any) that these companies were likely to make.
While the market throws out a lot of data about the economy and companies in particular, no number can truly give an idea as to whether the market is pricing in fear—sending prices generally higher than they should be—or greed, where prices are lower than they should be. That’s where judgement comes in, and a willingness to think about the market logically.
Investors who can ignore their own emotions, and even act against them, buying during periods of fear when others don’t want to buy, and selling when everyone looks at the recent rally as just a starting point for future profits, will do better over time by taking advantage of that one trend.
Traders who follow this strategy are more likely to buy bargains, giving them an edge and margin of safety on their trades. These traders are also likely to sell into the frenzy, getting out with a great profit and leaving a little bit of upside left for traders right before the top of a trade.
It’s a far cry from many traders who buy something that’s going up simply because it’s going up—or traders who buy more of something going down in the hopes that it will recover soon.
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