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Emotion and Psychology
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IntroductionPeople participate in the financial markets for a variety of reasons. Some do it only for the profit, and some because they enjoy it - it's the journey. Some people see it as a job, and it's what they do to earn a living, because they need the proceeds as an income source - either the dividends, or the capital growth.
When a company's share price rockets upward, or dives downward, it is because enough of the market participants have a strong enough view of the stock, or of the market generally, to cause the share price to move. They have an opinion about the value of the shares. This can change from time to time depending on the general economy, and many other influencing factors. Overall, we could describe this as investor sentiment.
Prices of financial instruments (such as shares, commodities, currencies, etc.) move up and down based on people's perception of value and their opinions about share price (perhaps using fundamental analysis), and because of the underlying emotions of fear, greed and hope.
If only the market participants and retail investors in particular could understand more about these underlying emotions, it would help to make more sense of the market movements.
And if the investors can be more in control of their own emotions, then their investment decisions can be made more calmly, with a cool head, without undue influence, and with a greater chance of success.
A simple test for you...Just by way of one small example, how observant do you think you are? - How much detail do you actually observe when you "see" something? Here is a "Selective Attention Test" short video on YouTube (less than 2 minutes). Watch the video and follow the instructions. The mind can easily play tricks on us, and sometimes, what we see is not what we think we see.
Crowd behaviourIt can be rather surprising that crowd behaviour can have such a dominant influence over the decisions of otherwise sensible and logical thinking people.
Crowd behaviour tends to take over once a share market price trend gets under way, and potential market participants start to suffer from FOMO (Fear Of Missing Out), and more and more investors climb into the market. Eventually prices reach an extreme where we see irrational exuberance, and then the inevitable price crash as the prices fall back toward a more reasonable level.
It is important to understand that the "crowd" tends to be right for a lot of the time, but the crowd gets it wrong at the extremes. The crowd misses out on the start of the rallies and uptrends, and the crowd tends to stay invested for too long - until way past the top.
The key for the astute investor or trader is to be able to get out when the crowd is still rushing in. But judging the timing is not that easy. Even so, technical analysis can certainly help us to protect our capital.
Cognitive, emotional and behavioural biasesMany investment decisions tend to be influenced by a variety of natural biases that we tend not to be aware of, including those that are classified as cognitive biases, and/or emotional biases. Some poeple refer to them as cognitive distortions. Here are just some of the more common ones:
The easiest person to fool is yourself!
Without realising it, the average investor can easily fall for any number of these biases. And the trained professional investors who are aware of all this (including the algorithmic traders, and the fast day traders) can easily take advantage of the predictable behaviour of the retail investors.
There are many different cognitive biases, emotional biases and behavioural biases. And depending on which reference material you read, there can be an overlap in these categories, and some biases might fit into two categories. Nevertheless, what is important to the average investor is that they are aware of these biases, and understand something about them so as to be able to avoid falling victim to them.
Emotion - GreedWhen we see a company's share price running higher, we can easily feel overwhelmed by greed, and by the fear of missing out, so we buy shares, only to see the price fall away. If only we had have stayed cool-headed, and not got carried away.
Emotion - FearMany investors have experienced that feeling of fear in our investing. Maybe it was the fear of suffering a loss, or the fear of missing out or the fear of being wrong about an investment decision.
Emotion - Hope
Hope is the third emotion that is worth mentioning. It tends to induce the investor/trader to focus on the outcomes that are rather favourable, while fear tends to induce the investor/trader to focus on the outcomes that are particularly unfavourable. Hope causes investors to look at possible outcomes from the top down and ask: “How good can it get?” Conversely, fear causes investors to look at possible outcomes from the bottom up and ask: “How bad can things get?”
The emotions are in the charts...
The price chart at right of CBA bank from October 2013 to May 2014 is a good example of this. For some explanatory comment about this chart and the horizontal lines drawn on the chart, see the Technical Analysis page
Prices of financial instruments (such as shares, commodities, currencies, etc.) move up and down based on people's perceptions of value (perhaps using fundamental analysis), and because of the underlying emotions of fear, greed, hope and regret.
If only the market participants could understand more about these underlying emotions, it would help to make more sense of the market movements. And if the market participants can be more in control of their own emotions, then their investment decisions can be made more calmly, with a cool head, without undue influence, and with a greater chance of success.
To understand more about how to read the emotions in the charts, and how to more accurately anticipate future price movements,
see the details on Technical Analysis...
Here's a tip:
If you can understand more about why the market works and responds the way it does, and understand the inherent investor sentiment, and the cognitive biases from which we might suffer, then you will be in a much better position to participate in the markets.
More informationAs you read more on this subject, you will probably come across a number of similar or related terms including: cognitive bias, emotional bias, behavioural bias, and behavioural finance. For more information on this topic, see the details above right.
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