Good read on market psychology When we buy a stock, we think the whole world must see the good things that we see. The truth is, for every stock we buy there is someone on the other side of the trade who disagrees with us. We should be humbled by the fact that for every trade, someone is going to be wrong.
You may buy a stock because you have learned something about the company that you think makes that company undervalued. The person selling to you may not know this new information and therefore does not believe that the stock is undervalued. They may know information that you do not know which makes them believe that the stock is actually overvalued.
These are called information asymmetries and they are the reason that trades in the stock market can happen. The buyer thinks the stock is undervalued and the seller thinks the stock is overvalued.
They are also the reason that companies with improving fundamentals do not go up steadily over time. Instead, most strong stocks will go up, then pull back, then go up, then pull back; they trade in this cycle which forms an upward trend line.
Emotion is a big factor in this trending trading pattern. When stocks go up quickly, investors are motivated by their fear of missing out and will chase the stock higher with their buying. This pushes the stock up too far, too fast and causes sellers to take profits and push the stock back down to rational level. The cycle of fear and greed brings a good deal of price volatility within an upward trend.
It is important to understand that information asymmetries and emotional decision making are at work in the market every day and on every stock because it can help us to know when to buy and sell strong trending stocks.
We should not chase a strong stock higher as it runs up and away from its trend line because it is likely going to pull back soon when the emotion wears off. Instead, we should buy on pull backs to the upward trend line because that is often when they make a bounce.
We should not sell just because there is some minor weakness that is merely a pull back in the longer term upward trend. Until the longer term upward trend line is broken, we should stick with the trade and be patient with the winner.