There are many catalysts that influence the stock market - the internal developments that take place within companies, worldwide events, inflation rates, interest rates, exchange rates and more. All of these factors affect the way stocks might rise and fall.
In addition to the impact of these actions and changes, though, there is an emotional and psychological influence at work. While many are familiar with the market cycle and its four stages (accumulation, markup, distribution and markdown), there is a parallel emotional cycle experienced by investors that is often overlooked. The behavioral responses of investors creates an investor cycle of emotion, which can equally influence market performance. The investor sentiment syncs with the components of the market cycle and simultaneously acts as both a coping mechanism for investors and a catalyst for volatility. Just as the market cycle experiences four stages, the investor cycle of emotion is structured the same. (For more, see: How to Avoid Emotional Investing.)
Stage 1: Pessimism
As the market cycle enters the accumulation stage after suffering from a decline in prices, many investors simultaneously enter the pessimistic phase of the emotional cycle. During the accumulation stage, asset values begin to consolidate and investors still perceive the market as bearish and are hesitant to buy. Investors believe the downtrend of market value is permanent and do not want to subject themselves to hope after having just lost their position within the market. They fear rejoining the market and experiencing further loss more than they fear missing out on the start of a new bull market.
Stage 2: Optimism
Seeing that the market cycle is transitioning into a markup phase, where prices continue an uptrend momentum, investors begin to shrug off their leftover despondency from the last cycle. Due to the actions of investors in the accumulation stage who invested in stocks at or near the market lows, the markets start experiencing higher highs and higher lows. The market is once again viewed as an optimal opportunity, and investors excitedly begin to invest again as they regain confidence in the market’s potential for returns.
Stage 3: Euphoria
Prices hit their highs, and while some investors are distributing their shares through selling, remaining investors celebrate their choice to participate in the uptrend and feel comfortable investing in additional assets. This coincides with the distribution stage of the market cycle. It appears as if the bull market will never end, and investors in the market will blindly push forward and position themselves at a point of high risk to simply prolong the feeling of success.
Stage 4: Fear
While remaining investors are reveling in their euphoria, the market begins a somewhat volatile downtrend due to the markdown of prices, the final stage of the market cycle. As the decline continues, doubt begins to creep into investors’ mindsets and eventually develops into full blown panic. Not wanting to sell at a loss, many investors hold onto their assets for too long and set themselves up for a delayed inevitability - having to sell aggressively as a way to relieve themselves of coping with the fear and anxiety of their holding’s performance, or lack thereof.
The cycle of emotion and market cycle both play a similar role in investing. To better understand the stock market and its up-and-down swings of volatility, investors should learn the signs of each stage of the market cycle and its emotion cycle counterpart. In doing so, they’ll be able to better understand their investment strategy and make better informed decisions when it comes to their portfolio. (For more from this author, see: An Investment Strategy for Market Volatility.)
For more information on low volatility investment strategies, you can download the whitepaper: Mastering Market Volatility Over a Full Risk Cycle.