Stock Market: Be Greedy When Others Are Fearful

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Source: Thinkstock

Source: Thinkstock

Buying out of favor stocks is one of the most difficult things to do. Often, when stocks fall dramatically, it does so for valid reasons. Furthermore, the lower they sink, the worse the news seems to get. Nevertheless, if you trust your ability to analyze companies then one of the best pieces of advice you can follow is to be greedy when others are fearful.

Keep in mind that stock prices go up for the same reason that the price of anything else goes up — supply and demand. When the price of a stock goes up, it does so because the price needs to rise in order to incentivize holders of the stock to sell their shares to those who demand it. Thus, a stock price rises in order to meet rising demand. But once the rise has taken place, some of the demand has been fulfilled, and there is less future demand.  This is inherently bearish.

Nevertheless, this is counterintuitive on some level. This is exemplified in the fact that stock prices rise after good news has been reported: positive earnings results, a patent approval, an increased dividend, a bullish report from a reputable analyst, and so forth. This last example — the fact that stocks rise on positive reports — gives us insight as to why a rising stock price is inherently bearish. If an analyst at a reputable firm is bullish of a stock, isn’t it likely the case that s/he is going to buy the stock before announcing this to the public? Why wait when s/he knows that there will be buyers entering the market as a result of this report? The very fact that they buy before the report means that the report is bearish insofar as it signals that there is less demand for the stock.

The same can be said about a falling stock price being inherently bullish for a stock. As the stock falls, there are fewer and fewer sellers, and this means that supply is drying up. From a supply/demand perspective, this is extremely positive. There is, however, a major caveat. A stock can go to zero. How, then, do you know the difference between a downtrodden company that has a positive long-term outlook and a company headed towards bankruptcy? While this is not an easy question to answer, being able to do so can make you fortunes.

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