In Part 1 of Crowd Psychology, I covered two primary topics:

1. The stock market follows the auction model
2. Crowd psychology influences investors

Before we dive into how to benefit from crowd psychology, let’s take a slight detour and discuss how stock prices actually move up and down.

How Stock Prices Move

There’s a limited number of shares of Google stock traded on the public markets. You can find on Yahoo! Finance that Google has a float of 235 million shares traded on the public market. Now let’s say that Google invented a time machine and plans on launching it a year from now, and everyone wants Google stock. Well, there’s a finite number of shares on the market (limited supply) and, all of a sudden, there’s tons of demand.

If Google is currently trading at $500, it is obvious (I hope) that nobody who owns Google right now would want to sell the stock at under $500. In fact, nobody wants to sell it for anything under $520. Let’s say that a guy named Bill (who thinks that another big company will beat Google to the time machine market, although his ownership in Google is suspect in the first place) is the only person that places the first ask price - that is, the price at which a seller is willing to accept a security - at $520. There’s all this pent up demand, and many buyers are more than happy to bid $520 for Google. When the ask and bid prices match, the buyer purchases the shares from the seller at the agreed upon price. Furthermore, the price of Google’s shares is now $520! The key point here is that the price of a stock is determined by the price at which the last trade took place.

To recap, Bill has sold his shares and the market now reflects Google stock at $520. Investors across the market suddenly see Google’s stock price jump from $500 to $520! In fact, in the time that they saw the spike, many more transactions have already taken place. Our next seller, Steve (who thinks that a different big company will beat Google to the time machine market), has abandoned ship at $550, only to have his shares snatched up by the mob of buyers as well. In the span of less than 30 seconds since news that Google has invented a time machine came out, Google’s price has already jumped from $500 to $550, and continues to rise!

Investors across the world pick up on the news, see the price going up and up, and suddenly feel the blood rushing to their heads as they quickly enter their own order to pick up shares of Google. Pretty soon, there’s a hysteric frenzy surrounding Google stock as even people people that don’t ordinarily invest have jumped into Google shares. The price skyrockets through the roof and has reached almost $2,000 in just a few hours, where finally the number of buyers and sellers has reached an equilibrium, and the stock price has plateaued.

Now, let’s say that the true intrinsic value of Google with the new time machine business is $1,000 (figuring out intrinsic value is the tough part in investing, and most of the time you will only be able to estimate). It’s clear that crowd psychology has pushed the price way out of proportion from its fair value. This example is identical to the Warren Buffet trading journal example, except it’s being applied to the stock market.

Why does this matter?

Well, first off, it’s good to know that the stock is trading at above fair value. But wait! That does not mean you should sell the stock yet! Just because a stock price is above its intrinsic value does not mean that the market will suddenly figure it out and jump back down. You want to identify the peak and sell there to maximize your profits! Of course, you usually don’t want to wait until the absolute last second because you might fall off a steep cliff.

In the next part, I’ll expand this concept to a discussion of the overall market and how to identify the signs of a peak.