When I wet sanded my car i used 1500# and then re sanded it with 2000#. Then I used a 3 stage buffing system. The first cut is used with a wool buffing wheel. Then the next 2 are used with foam buffing wheels.
You should search and read about color sanding and buffing techniques.
I'm guessing you are wet sanding after you sprayed the clear coat correct? There are ways to color sand each layer of base coat before the clear coat, but that is usually for higher end paint jobs.
The whole idea of wet sanding is to smooth out the CLEAR coat, without going into the paint.
If it still looks good when water is over it, that is a good sign. What you are trying to do is to sand out the orange peel. When you first start sanding, you will notice slight ripples or bumps in the area you sanded. You want to keep going until the surface looks uniform, but don't do one spot too much. You want to be sure not to bust through the clear coat, and have enough clear left over to protect the paint.
Don't apply any pressure when sanding either. Just let the sand paper do the work.
Now I am far from an expert, but I would suggest getting some higher grit sandpaper, like a 1500 or 2000 or even higher if you want. Sand until you can't see any scratches left over from the previous grit.
Then you'll want to take your buffing compound, and use a generous amount of it, and start buffing it in with an electric polishing wheel. Don't let it dry. Do small segments at a time, about a square foot section. When done, wipe it away with a clean dry cloth (I used a microfiber) and then continue.
There are some really good write ups on the site if you search for it.
Here's some pictures to help you get started. You want to be VERY careful with the edges, as they are the most vulnerable to being sanded through to paint. So I covered them with automotive painter's tape as i was sanding.
After polishing an area