What is the psychology of the market and why should investors care?
In the current period of higher volatility, higher inflation, higher interest rates, higher prices (for what seems like everything), higher valuations, higher expectations, higher awareness…Should I buy? Should I sell? Better yet…what should I buy? What should I sell? It can be mentally and emotionally draining – even for investors who have wisely hired an investment advisor to manage their investment portfolio on their behalf.
Market psychology refers to the prevailing behaviors and consensus sentiment of the market based on the aggregate of individual market participants. It applies to all asset classes including stocks, bonds, foreign exchange, cryptocurrencies, and non-fungible tokens to name a few. Greed, fear, anxiety and excitement all contribute to market psychology at different times. Market psychology describes the overall sentiment steering the market trends and price action. Instead of being rational actors, we humans are greatly influenced by cognitive and emotional biases and are subject to the sway of the herd instinct. The ability of these different moods or states of mind triggers periodic risk-on and risk-off – in other words, boom and bust cycles in financial markets.
Conventional financial theory, most notably the efficient market hypothesis (“EMH”), is criticized for not adequately accounting for market psychology. EMH describes a world in which all market participants behave rationally, and it fails to account for the emotional aspects of the market. Market psychology can lead to an unexpected outcome that cannot be predicted by studying fundamentals. It is at odds with the belief markets are always rational.
Broadly speaking there are two prevailing methods of stock selection and only one of those methods gives much attention to market psychology.
– Fundamental analysis aims to invest in stocks by analyzing the company’s financials within the context of its industry. Market psychology doesn’t typically find much of a place in the deep dive of number crunching financial ratios.
– Technical analysis focuses on trends and patterns and other indicators which drive prices of stocks higher or lower. Market psychology is one of those drivers.
Indeed, the principles of market psychology underlie the motivations behind technical analysis, a method which identifies opportunities to buy and sell by analyzing historical price and volume trends. A good grasp of crowd behavior is therefore helpful for revealing the workings of certain technical indicators.
So, what does market psychology teach investors? Markets are a consensus of human choice and can display herding behavior and irrational tendencies like panic selling or euphoric exuberance, which lead to asset bubbles. By acknowledging the existence of market psychology, investors can understand markets are not always efficient or rational. While fundamentals will drive stock performance over the long run, market psychology can override the fundamentals, pushing prices in an unexpected direction for periods of time.
How can investors use market psychology to their advantage? Through research, investors can identify when market psychology like fear or greed or panic or euphoria results in overbought or oversold conditions. They can then make informed decisions to buy or to sell based on fundamental and technical research combined with current market sentiment.
Successful investing is hard. It requires experience and strategy and discipline and patience and a lot of work. It is, as they say, best left to professionals.
M. Brian Wachsler
Director
Disclosures:
There is no guarantee investment strategies will be successful. Investing involves risks including possible loss of principal. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit.
All expressions of opinion are subject to change. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investors should talk to their wealth advisor prior to making any investment decision.
