Stock Market: A Plain-English Introduction Part 2: People, Psychology, and Price

In Part 1 (read here), we covered what stocks are, how companies and shareholders benefit from them, and why earnings drive stock prices. In this post, we’ll shift from the business itself to the people buying and selling it, and examine how psychology drives the market from day to day.

A company’s business changes little from week to week. Why, then, does its stock price swing — sometimes wildly — day in and day out?

At any point in time, the stock price represents the collective judgment of everyone buying and selling — based on what they know and what they expect. As new information comes out — a competitor slashes prices, inflation numbers tick up, a company reports unexpected sales figures — buyers and sellers revise their expectations about the business’s future value.

But that judgment is far from cold or objective. The market is a collection of millions of people with different information, goals, fears, and time horizons. All of them are constantly trying to predict the future, with many driven as much by emotion as by reason. Where a calm observer might see a minor setback, a panicked crowd sees serious trouble. Where a steady analyst sees normal progress, an excited crowd may see unlimited potential.

As a result, a company’s stock price can deviate surprisingly far from its true value. To see why, it is helpful to know who is participating in the market and what drives their decisions.

Who are these buyers and sellers?

Many are institutional professionals — mutual funds, pension funds, hedge funds, and bank trading desks, among others.¹ These are sophisticated organizations with large teams, powerful technology, and decades of experience.

Alongside them, on the very same exchanges, are millions of ordinary people like you and me, people saving for retirement, chasing a hot tip from friends, social media, or the news, or simply getting curious after reading an article. Both groups, through their collective trades, move prices. 

Do all participants have a similar approach to the market?

Not at all. Think of everyone sitting along a spectrum, with pure speculation at one end and pure investing at the other — something we hinted at in Part 1 when we asked what kind of owner you actually are.

At the speculating end is someone who buys on a whim, a gut feeling, or a hot tip. They often have a limited understanding of the underlying business. They’re essentially betting on what others will pay for the stock later.

At the investing end is someone who has done deep research, developed a careful view of future earnings, and is buying because they believe the market has mispriced the business and is willing to wait for that to be recognized.

Most of us fall somewhere in between: part speculator, part investor, in different proportions. Even the most uninformed speculator can make money sometimes, and the most seasoned investor can lose money sometimes.

Is having a speculative streak problematic?

Not inherently; it’s almost a natural human trait. The speculative streak becomes problematic when it dominates without you realizing it, so you think you’re investing when you’re actually speculating.

Part of what makes that line so easy to blur is how effortless the stock market makes trading feel. Making money typically takes effort and time. You might spend months renovating a house before selling it for a profit, or years building a business. Even buying and selling a car involves negotiation, paperwork, and effort.

Stocks are different. With a few clicks, you can own a piece of a global company and sell it just as quickly — no meetings, no paperwork, no phone calls. That ease can trick you into forgetting you are buying a slice of a real, messy business with real employees and competitors — and instead treating stocks as symbols on a screen to trade in and out of.

When the speculative instinct dominates, it often leads to frequent buying and selling, sometimes within days or weeks. It also triggers strong reactions to day-to-day news. This pattern is hard to sustain profitably over time.

Does following someone else’s lead make you more of a speculator?

It depends on how you use it.

Reading an analyst’s report, understanding its reasoning, and forming your own view are part of investing. Professional research is an investing tool.

But there’s a different kind of reliance that quietly shifts you toward the speculative end. You watch a money manager on CNBC make a confident case and buy the stock. Or you see that Warren Buffett has bought a company and decide, “If it’s good enough for him, it’s good enough for me.” Or you read that a well-known investment firm has put a “Buy” recommendation on the stock, and that feels like sufficient reason.

In these cases, you may be borrowing someone else’s conclusion without fully understanding the reasoning. You don’t know their assumptions, how long they plan to hold, or when they might change their mind.

The real test comes when the stock falls sharply. If it falls 20%, do you have your own understanding of the business to decide whether to hold, buy more, or sell, or does panic take over? That’s the difference between using outside analysis as an input and simply borrowing someone else’s conviction.

Are professionals any more rational than the rest of us?

Less so than you might expect. Both groups can behave irrationally, just for different reasons.

Market professionals are formally evaluated and held accountable, which can encourage herding behavior. When a popular stock is rising fast, a professional who stays on the sidelines risks looking foolish. It often feels safer to be wrong with the crowd than wrong alone.

That said, this same accountability imposes a degree of discipline — professionals may herd, but they typically avoid acting on pure impulse. Every move they make gets reviewed.

Everyday investors, on the other hand, have complete freedom — no boss, no risk committee, no formal review. Driven by the hope of a quick win, they can turn an emotional impulse into a real trade in seconds.

So does anyone make truly rational decisions? Some do, some of the time. But no one is immune to emotion. When the people influencing prices are driven in part by fear, greed, and herd instinct, the prevailing price will sometimes be imperfect.

That gap between what a stock should be worth and what it actually trades for is both the market’s great flaw and, for patient and clear-eyed investors, its great opportunity.

Beyond psychology, do professionals have other advantages over ordinary investors?

Yes. Professionals have significant advantages in information, tools, and speed. Large firms spend heavily on specialized data and tools unavailable to ordinary investors. Their computers execute trades in microseconds.

These advantages matter most in short-term trading. As we’ll see in Part 3, there’s a different approach where they largely disappear.

If so many people are acting emotionally, what actually happens to prices?

Two emotions tend to drive much of the short-term movement: greed when prices are rising, fear when they are falling.

When a stock is rising, greed and the fear of missing out trigger more buying. When it falls, fear triggers selling. The result is often momentum: stocks that keep rising simply because they have been rising, and falling simply because they have been falling.

During the dot-com boom of the late 1990s, investors paid extraordinary prices for technology companies with no earnings at all, purely on excitement about the internet’s potential. Eventually, many of those stocks lost 80 or 90 percent of their value.

In the short term, success often depends less on assessing a company’s value than on guessing what the crowd will do next.

Does the market ever correct itself?

Yes. A company that keeps growing its earnings will eventually see its stock price reflect that, and a company that disappoints will eventually be priced lower. The market can stay irrational for months or even years, but over time, business quality and earnings tend to prevail.

Investors who can stay the course long enough often benefit. But staying the course is harder than it sounds, partly because crowd emotion affects more than current prices. It also affects how stock ownership changes over time.

So crowd emotion doesn’t just move prices — over time, it can actually change who owns the stock?

Exactly.  

For instance, when Cisco faltered after the dot-com boom, even its steady long-term holders began to reassess. The stock fell sharply, not just because the business had hit a bump, but because the aggressive growth investors it once attracted were no longer the right owners. The price had to fall far enough to find a different audience with more conservative expectations.

When we purchase a stock, we are joining a specific group of owners at a specific moment in the company’s story. The price reflects not just the business, but who currently owns it and what they expect from it. When that group changes — when the story the crowd believes in shifts — the price must find a new level, even if the underlying business has barely moved.

Understanding who owns a stock and why they own it is central to serious investors’ focus, which brings us to valuation.

How do serious investors cut through all the noise?

They anchor themselves to something more stable than crowd sentiment: the business’s actual earnings power. The simplest and most widely used tool for this is the price-to-earnings ratio (P/E), as we discussed in Part 1.

Think of the P/E not just as a valuation tool, but as a thermometer of crowd emotion.

A very high P/E means the market is paying a premium, betting on strong future growth. A very low P/E ratio means the market is pessimistic and pricing the stock as if the business is in serious trouble. A serious investor’s job is to decide whether the market’s judgment is overly optimistic or overly pessimistic.

A high P/E isn’t automatically bad, but it means a lot has to go right for the investment to work out. A low P/E isn’t automatically a bargain, but it can signal that the crowd has given up on a company with potential.

Historically, a P/E of 15 to 20 has been considered roughly average for the broad U.S. stock market, though it varies by industry. Fast-growing technology companies often command higher P/Es, while slower-growing businesses, such as utilities, tend to trade at lower multiples. The number only makes sense in context.

One important caveat: as we saw in Part 1, accounting rules can shape reported earnings, which means the P/E ratio is only as reliable as the earnings figure underneath it.

If earnings are the ultimate anchor, what actually moves them?

Two broad categories. The first is company-specific events: a new product, a leadership change, a patent win, a regulatory setback, a costly lawsuit — any of these can significantly affect earnings. You can reduce some of these risks by spreading investments across many different companies, something we will return to in Part 3.

The second is the broader economy, including crises, employment, inflation, and especially interest rates.

Interest rates act like gravity on stock prices. When rates rise, bond yields rise, borrowing costs go up for both businesses and consumers, and consumers tend to spend less. This dynamic squeezes company earnings from both sides. Stocks become less attractive by comparison, and prices generally fall.

When rates fall, the reverse happens. Stocks become relatively more appealing, and prices tend to rise. Broader economic risks like these are much harder to protect against.

Can an individual investor realistically track all of this?

Not really, and you don’t have to. Following all of it is a demanding, full-time job. Even professional analysts who devote their careers to just a handful of companies still get things wrong regularly.

If investing is this complex, and professionals with every advantage struggle to win consistently, should an everyday person even bother with stocks? That’s exactly the right question, and the answer is surprisingly encouraging. We’ll get there in Part 3.

Notes

¹ A brief description of the main institutional players: Mutual funds pool money from thousands of ordinary investors to buy stocks and other assets. Pension funds invest the retirement savings of teachers, firefighters, government workers, and others, aiming for steady long-term growth. Hedge funds manage money for wealthy individuals and institutions, often using aggressive strategies — including short selling (betting that a stock’s price will fall) and leverage (borrowing money to invest more than they actually have) — to try to generate returns regardless of market direction. Bank trading desks buy and sell stocks to generate profits for the bank.