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Saturday, 19 September 2009

Think of Investing in Stock Market as Game of Tug of War


By Jeffrey D. Voudrie, CFP

Think of investing in the stock markets as a game of tug of war. We all remember playing this game in gym class, with people pulling on either end of a rope, with a flag tied in the middle. The goal is to get the flag to your side as quickly as possible, and of course, to embarrass the other side by your superior display of strength. Of course, it didn’t always work out that way and I have been on the side of the falling team more than once!

This is how investing works in the stock markets. We often think that the value of a stock is based on the company behind it, but that is only partly true. Think of the company as the rope in a game of tug of war. It’s not just the quality of the rope (cw8888: fundamental analysis FA) that will decide which team wins, it’s the players competing on each side (cw8888: technical analysis TA) .

On one side of a ‘stock’ rope, you have investors who believe the stock is going up in price. On the other side is another group of investors equally convinced the stock price will go down. The side that puts up the most money will determine the direction of the stock price.

Unlike in real tug of war, the players in the stock market can change the amount they have invested and even the side they are on at any time. Some players might change several times in a day. Others might stay on one side for years.

This switching of sides is what results in huge swings in the stock price. If one side of the rope becomes overloaded, then they have the power to quickly pull the rope their way. If you have a lot of people and money on one side it’s not going to be much of a contest.

In the real game of tug of war, the game is won once the flag moves a set distance. Then both sides quite and move on. The stock market tug of war is much more fluid. Players can come and go. Some might quickly take their profit or cut their loss short. Others may wait until it looks like one side has won before joining the game on the opposite side.

Moreover, each player may have a different strategy that determines what side they play on—or whether they play at all. Some focus on the quality of the company (the rope). Others look at the statistics of what’s happened in that tug of war in the past . And there are some that just seem to walk up and pick a side without any rhyme or reason.

Outside events also play a role in the quality of the rope and the decisions of the players. There might be a hurricane affecting the oil supply. The expected outcome of an election could impact regulation. Housing prices can go up or down.

The decisions made by professional players have a much greater impact on the outcome of the game than do those of individual investors. That’s because they have a lot more money to invest. If all the professional investors switch to the same side, the individuals on the other side are going to get embarrassed!

Looking at a single game of tug of war allows us to get a general understanding of the underlying dynamics involved in the movement of the price of a stock. The movement of a market or a market index is really the sum of all the underlying battles taking place.

The S&P 500 index represents the result of the tug of war occurring in 500 specific companies. The Dow Jones Industrial Average represents 30 select companies.

Successful investing isn’t solely about choosing which rope, but also choosing the right side. And it’s vital that you take into account what the other players are or will do. You won’t always get it right (nor should you expect to), but understanding why markets move will help you make more logical and informed investment decisions.

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CreateWealth8888:

Well said. Successful investing required both fundamental (right rope) and technnical analysis (increasing the chance of choosing the right side).

To share some of my thoughts, learning and experiences.You may wish to read more articles on the left under "To share some of my thoughts, learning and experiences ..."





1 comment:

  1. its been a long time reading about the Mortgage notes for sale I have really got my hand into this thing, few years back.

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