How do you think the stock market works? I don't mean that question the obvious way – that it's a place where people buy and sell stocks through brokers. What I mean is: how do you think stock prices are really set? What is your mental model of how prices are decided?
A flawed mental model can lead to some interesting conclusions. For example, in the early days of email, a friend of mine believed that if you reduced the font size in an email message, then the message would become smaller and therefore easier to send. It was a flawed mental model, or rather, was the fax mental model being applied to email.
I believe one of the fundamental reasons why so many people have trouble investing in the stock markets is that they have severely flawed mental models of what determines stock price. While there are many mental models of how the stock markets work, some are more common than others.
This is the most widespread one: 'There are people who know when a stock's price is about to rise. If one of them tells me, then I can make money.' This is the 'tip' model of the stock markets. It isn't so much a mental model as the lack of one. Unfortunately, this is a very common one. There seem to be a lot of people who believe that someone out there knows which way things will move and everything depends on somehow getting to know these secrets.
A little broader than the 'tip' model is the 'operator' model. Under the operator model, people believe that there are people ("operators") who manipulate stocks and what one needs is to figure out what the operators are doing and then somehow manage to ride the stock while the operator is pushing it. This model is actually realistic. Outside the big, high volume tickers, many, many stocks are routinely manipulated by the so-called 'operators', at least in the short-term.
However, this model is useful only for the operators themselves. To succeed, operators need greater and greater fools to buy into the stock they are operating on. Basically, if you are not an operator yourself, you are under considerable risk of giving away your money to an operator. For a surprisingly large number of people – many of them regular investors – the markets are primarily driven by conspiracy. There are secret cabals of operators who decide practically everything and then they just make it happen.
There is, of course, yet another model. This one is about researching companies, figuring out their businesses, projecting what could possibly happen in the future and then deciding which stocks to buy, which not to buy and when to sell the ones you have bought. However, compared to the 'tip' model and the 'operator' model, such a small number of people believe in it that perhaps it's just a fringe idea. What do you think?
This story first appeared in May 2012.