The Stock Market Lottery Ticket
Now that you have bought your stock, let's hope you win
The stock market uses an obscure term to describe its function, namely stock which is actually an accounting term derived from trading stock which is simply the products a business sells.
A more accurate and informative description for buying stocks is buying company shares.
Buying a share of the company is what the stock investor is actually buying. This means the stock investor is now a part owner of an actual business which sells a product or provides a service.
For many stock investors (particular beginner investors), buying a stock is treated more like buying a lottery ticket. They simply buy their stock lottery ticket and hope they win.
This mentality explains why stock prices can become so excessively high relative to what the business is worth.
These stock investors are often surprised to learn that the stock they bought was an actual business and that they are a part owner of it.
The main attraction these stock investors have towards a particular stock is with the stock's price history.
Stocks that have significantly increased in price over a period of time (such as the last year or two) are seen as attractive investments as the annual returns have been spectacular.
After all, no stock investor wants to miss out on these returns and the seemly consistent stock price appreciation provides confidence that these returns should continue unabated into the future.
These stock investors, having no idea of what they have bought, make no connection with the stock's relentless price increase and the worth of the company. The only thing that is important to them is that the stock's price history has shown impressive capital returns.
They will typically find any excuse to justify why the stock's price should continue to increase.
Investors have a tendency of buying a rising
stock price rather than a growing business
In the world of consumer spending, the consumer is generally reluctant to pay more for purchases than what they think they are worth.
Given the chance, the consumer will aggressively pursue any bargains they may come across.
However, when these same consumers become involved with the stock market, any logic they exhibited with their consumer spending is completely dismissed and replaced with an irrational gambling mentality.
These irrational thought processes are best illustrated with an example.
The Increasing Stock Price
A company that is valued at $10 has been increasing in price over the last six months and is currently trading at $20.
For many stock investors, they will see the stock price increase as a sign that this is a great investment and so they buy some stock for themselves.
Their own buying adds to the demand for the stock and while demand exceeds supply, the stock's price will continue to increase.
Some stock investors were hesitant and did not buy the stock at $20. The stock's price after another six months has now reached $30. These stock investors who missed out are now convinced that the stock's price is just going to keep increasing and now purchase the stock.
After all, they don't want to miss out on any more of the profits.
For other investors who bought another stock at say $20 and saw their stock plunge down to $10, they are skeptical of this stock trading at $30. They don't what to risk another loss.
The stock's price after another six months reaches $50. The skeptical stock investors who had the losses from another stock see this stock which is now at $50 and conclude that this stock must be a good investment as the price just keeps going up. They decide to buy this stock at $50.
The stock investors who bought at $20 or $30 are now regretting that they did not buy more. They are convinced that this is a fantastic investment and do not want to miss out on further gains, so they buy more stock at $50.
The buying pressure from these stock investors keeps the demand up for the stock, which keeps driving the stock's price higher. This will continue until some event causes the stockholders to decide to sellout. When this occurs and sooner or later it will with an overvalued stock, the supply then exceeds demand and the stock's price tumbles.
The event can be anything, but inevitably it is something that causes the rationally thinking stockholders to decide to sell their stock at these overly inflated prices before prices drop back to what the stock is worth.
Ironically, it is actually the selling pressure from these rationally thinking stockholders that fuels the increased supply which now exceeds demand.
These rationally thinking stockholders are scrambling to lock in their impressive capital gains before stock prices drop, as they typically bought when stock prices were around what the stock was worth.
As the example stock was worth $10, the lottery ticket investors who bought at $20 or $30 enjoyed some capital gains for a while, but after the stock' price tumbled they are now faced with a significant capital loss. For the lottery ticket investors who bought stock at $50, they did not even enjoy any gains and are just faced with their significant capital losses.
Many of these lottery ticket investors will sell their stock at these now low stock prices just to make the psychological pain of enduring a relentless price decline go away.
Their irrational logic now dictates that the stock's price will just keep falling with no bottom in sight.
These lottery ticket investors with their irrational logic are an important component of the stock market as they are the stock investors who provide the demand to drive stock prices way above their valuation, which provides the savvy stock investor with opportunities to profit from.
Indeed many speculative traders participate in these relentless uptrends.
The primary difference is these speculative traders are fully aware that at these prices, the stock is a bad investment. They only buy the stock to sell it shortly afterwards for a small capital gain, rather than holding the stock as an investment.
Stock Analysis for Finance Students and Investors