Brainy's Share Market Toolbox Brainy's
Share Market Toolbox

Emotion and Psychology
of the markets


The day-to-day and week-to-week performance of companies in the share market
depends on the underlying mood and sentiment of all the investors and traders
who participate in the market. 

Understanding this can bring greater success...
 

More information

For more information on related topics:
Cognitive Biases - see Wikipedia.
Behavioural finance and behavioural economics.
www.behaviouralfinance.net.
Also: behaviouralfinanceaustralia.com.au.
Trading psychology.

Share Market Terminology - See Brainy's eBook Articles, and the Master Index list for details.

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And whatever you do,
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Introduction

People participate in the stock markets of the world for a variety of reasons. Some do it only for the profit, and some because they enjoy it. Some people see it as a job, and it's what they do to earn a living, while some people do it because they need the proceeds as an income source.

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.

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.

Cognitive, emotional and behavioural biases

Without realising it, many investment decisions are 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. Here are just some of the more common ones:
  • 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.
  • 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.
  • 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 easily falls 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 predicatable behaviour of the retail investors.

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, ot the fear of missing out or the fear of being wrong.

Biases - more details

There are many different cognitive biases, emotional biases, and behavioural biases. And depending on which reference material you read, they 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.

The emotions are in the charts...

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.

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...

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.
This is one of the many tools in Brainy's Share Market Toolbox.

The information presented herein represents the opinions of the web page content owner, and
are not recommendations or endorsements of any product, method, strategy, etc.
For financial advice, a professional and licensed financial advisor should be engaged.


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Last revised: 7 November, 2014.