Brainy's Share Market Toolbox (public information)

Emotion and Psychology in the markets

More information For more information on related topics: eBook (PDF) Article ST-2122, "Psychology and emotions" (or see the free page 1 here). Robert's public presentation slides on Psychology and Emotions of Investing and Trading. Cognitive Biases - see Wikipedia.  Behavioural finance and behavioural economics. www.behaviouralfinance.net. Simon Russell's  behaviouralfinanceaustralia.com.au. Trading psychology. Share Market Terminology - See Brainy's eBook Articles, and the Master Index list for details.  Or, search the eBook Articles. Robert writes information for Share Market Toolbox members about the market and investing. Or you can register to receive useful free information from time to time as it is published. Click here to register interest For Email Marketing you can trust Privacy ensured, unsubscribe anytime. See the Testimonials - the things that people say about the Toolbox and more. Who is Robert Brain? - Robert provides support to both new and experienced traders and investors. Brainy's Share Market Toolbox The toolbox is an arsenal of weapons to help you tackle the share market.  See a list of contents on the Toolbox Gateway page. The Share Market - more information about the market and investing and trading. And whatever you do, beware of the sharks in the ocean! Introduction People 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 behaviour It 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 biases Many 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: Recency bias - The tendency for investors and traders to place more importance on more recent trades and to place less importance on less recent trades. Herd instinct - Most people don't like to go out on a limb and do something different to everyone else, so they tend to follow the decisions of the masses. Overconfidence effect - Excessive confidence in one's own track record, and answers to questions. This can lull us into a false sense of security, and overconfidence in our ability. It impacts on many aspects of our lives. Anchoring bias - The tendency to "anchor" (rely too heavily) on one piece of information when making a decision. Confirmation bias - The tendency to look for information that confirms our existing preconceptions, making it more likely to ignore or reject information that is not in line with our beliefs. For example, when we compare ourselves with others we are more likely to remember other people's mistakes and less likely to think of our own. Familiarity bias - This is based on the idea that people feel more comfortable with something which is familiar, rather than something which is not. This can refer to investing in some particular companies in preference to others, or in one sector in preference to other sectors. 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 - Greed When 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 - Fear Many 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... Weekly price chart of CBA  from October 2013 to May 2014. Many people don't realise it, or refuse to accept it, that the underlying opinions and the emotions of market participants are summarised in the price charts. People participate in the stock markets of the world for a variety of reasons. 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.   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 information As 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. Back to Top

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