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Investment Series: Why Rising Stocks Always Pullback?

Oct 17, 2007
We've all been frustrated in the stock market before, haven't we?

Did you remember the time when you identified a really good stock with really good news on its heels and rallying strong? However, just a couple of days after you buy shares of that company, it pulls back and you incurred a loss? Even worse when you used futures on that stock instead?

Didn't it make you wonder why such strong stocks pull back so strongly? In fact, why does stock markets even pullback as a whole?

There is an explanation to this and it is what we refer to in economics as the "Law of Diminishing Marginal Utility". The Law of Diminishing Marginal Utility states that as consumption of something increases, the satisfaction (marginal utility) of having that something decreases as every unit of that same thing is given to that same person.

Too abstract? Well, it really means in layman terms that the more of something a person have, the least the satisfaction in that thing in question. Have you ever been to a buffet? Can you remember the satisfaction of that first taste of food after having prepared for this by starving for the day? However, can you remember how less satisfied you feel with every new plate of food until you can no longer derive any satisfaction from eating?

That's the exact same thing happening in the stock market.

The satisfaction of a profit diminishes as more and more profit is made, to be replaced by the fear of losing the profits already made. It will come a point in time when the satisfaction of more profits becomes zero to be totally consumed by the fear of losing the profits that was already made. At that point onwards, investors start taking profit by selling and thus a pullback in price. That point seems unusually correlated amongst human beings and once the first sight of profit taking occurs, the rest succumbs to their fears too and sell off.

Did you remember the first time you made a profit in the stock market? Did you remember how it felt when the figures turned green in your trading account for the very first time? You were elated, weren't you? You wanted more profits, didn't you? However, did you remember how more and more uncertain you became as the profits grew higher and higher? Did you ask yourself if you should continue to hold on and bet for more profits or simply get out while the going is good? Did it come a point where your fear of losing that profit totally consumed any satisfaction derived from have more possible profits? What did you do then?

Well, we all know that now, don't we?

So, the Law Of Diminishing Marginal Utility made certain that no stock nor market go up ceaselessly so nobody, but the most disciplined and patient investors could make a consistent profit. Are you that kind of disciplined and patient investor?
About the Author
Jason Ng is the Founder of Masters 'O' Equity Asset Management, a fund manager specialising in options trading. His Star Trading System has helped thousands. Please visit MastersoEquity & OptionTradingpedia.
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