Stock Market Psychology: Use it To Your Advantage

Stock Market Cycles Chart

Stock Market Psychology

Grasping the stock market psychology is not too hard, but many investors are unaware of its existence or thoughtlessly neglect it while planning their investment strategies. 

For long it was thought that the stock market must act rationally and sooner or later correct itself. Some investors still hold onto this belief, which is known as the "efficient market hypothesis". 

However, in modern times market psychology has been prone to more in-depth research. Nobel prize-winning Daniel Kahneman was one of the first economic researchers to doubt the validity of the efficient market hypothesis. Together with the famous cognitive and mathematical psychologist Amos Tversky they challenged the notion that the markets would always make rational decisions made on relevant and publicly available information. They made the case that humans suffer from a palpable cognitive bias when it comes to financial decision-making and specifically while investing. Thus, they pioneered market psychology. 

Daniel Kahneman also wrote a book about behavioral economics called "Thinking, Fast and Slow", which we highly recommend at Investors Psychology.

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What is Stock Market Psychology?

• The stock market psychology is mostly synonymous with market psychology, only that it's applied specifically to the stock market. One could argue that every market is affected by one another and the economy as whole and as such making the term redundant.
  
  
• However, this is not completely true. The US stock market alone is worth multiple trillions of dollars and is the market that people will most likely participate in during their lifetime (aside from the real-estate market, where most do not participate as investors).
  
  
• In a nutshell market psychology tries to explain market movements by taking into account human behavior and emotions, taking into account the sentiment of all major participants in a given market. There might be market upturns or downturns that might not be possible to explain rationally or with financial fundamentals.
  
  
• Instead, the market might be driven by collective cognitive biases, such as fear of regret, loss aversion, and recency bias - leading to irrational behaviors such as panic selling, fear-of-missing out, and irrational exuberance. Furthermore, a generalized behavioral pattern of the investors collective mind can be summarized into the stock market cycles chart, which visualizes market cycle psychology in a simplified way. 

Photo by Markus Spiske on Unsplash

Stock Market Cycles

In general, the price trend and movement of different markets tend to follow similar patterns. This can be attributed in large due to market psychology. The stock market cycles specifically consist of the accumulation phase, the following increase in price called the markup phase, afterwards follow distribution where price action is even for a short while, before the inevitable decline takes place. 

As seen in the stock market cycles chart above the article, the collective thinking results in a predictable pattern. Each phase has corresponding sentiments connected to the price action.

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Applying Stock Market Psychology as an Investor

Aforementioned market movement holds particularly true in market bubbles. In such bubbles, the notorious fear of missing out (also abbreviated and known as FOMO) is running rampant and the market moves irrationally, and yes, probably longer than one can stay solvent. 

It's of utter importance to have some grasp of the stock market psychology and stock market cycles when investing. The information can be beneficially used on a macro scale when investing, such as guiding investment strategies over several years. It can be applied to all markets - including commodities and cryptocurrency markets. 

However, it cannot be used for guiding investments into individual stocks. In such cases, fundamentals such as p/e, balance sheets and growth play a much more important role. That being said, fundamentals can be overridden by market psychology and lead to unexpected results when investing.