The stock market is a fascinating compilation of information and emotion. If you really want to beat the market, you need to understand how it really works. Of course, you probably know that by purchasing 100 shares of stock XYZ, you are essentially becoming an owner of the company. Do you, however, understand the emotions of the stock market and what drives prices up and down?

The stock market obeys rules that are exactly the opposite of the traditional supply and demand model of economics. Conventional economics says that (assuming constant supply):

• When price rises, demand falls
• When price falls, demand rises

This makes sense, right? If the price of gas at the pump suddenly jumps to $4/gallon today, you’re going to consume a lot less gas than you usually do. On the other hand, if it suddenly fell to $2/gallon, you’d be more inclined to consume a lot more gas.

The stock market, however, follows the auction model:

• When price rises, demand rises!
• When price falls, demand falls!

How can this be? Well, you can thank your human emotion friends, greed and fear, for this strange phenomenon called crowd psychology.

Let’s look at an example. We’re at an antique auction and there’s an old Warren Buffet trading journal - the contents of which have never seen public light - being sold. The middle-aged woman to your right starts the bidding at $100. After a few moments delay, a businessman in the front bumps it up to $200. The young college student to your left suddenly decides to offers $300. Before you know it, five more people have entered the bidding war as the bid skyrockets through the $1,000, $2,000, and $5,000 marks like a knife cutting through butter. The room has entered into a hysteric frenzy. At this point, your blood pressure has risen considerably, greed has gotten the better of you, and you start wondering if you should place a bid to obtain Buffet’s prized possession.

Well, this phenomenon is exactly what happens in the stock market. In Part 2 of this series, I’ll discuss the details and implications so that you benefit from understanding crowd psychology.