What Is Market Psychology?
Market psychology refers to the prevailing sentiment of financial market participants at any one point in time. Investor sentiment can and frequently drives market performance in directions at odds with fundamentals. For instance, if investors suddenly lose confidence and decide to pull back, markets can fall.
- Market psychology is the feeling and mood of the market participants at a given point in time.
- Emotions, including greed, fear, excitement and irrational exuberance can all contribute to market psychology at any time.
- The conventional financial theory fails to account for the role of investor emotion in trading, as well as how emotion can contribute to irrational behavior.
Understanding Market Psychology
Greed, fear, expectations, and circumstances are all factors that contribute to markets’ overall investing mentality or sentiment. The ability of these states of mind to trigger periodic “risk-on” and risk-off,” in other words boom and bust cycles in financial markets is well documented. Often these shifts in market behavior are referred to as “animal spirits” taking hold. The expression comes from John Maynard Keynes’ description in his 1936 book, “The Theory of Employment, Interest, And Money.” Writing after the Great Depression, he describes animal spirits as a “spontaneous urge to action rather than inaction.”
While conventional financial theory, namely the efficient market hypothesis, described situations in which all the players in the market behave rationally, not accounting for the emotional aspect of the market can sometimes lead to unexpected outcomes that can't be predicted by simply looking at the fundamentals. In other words, theories of market psychology are at odds with the belief that markets are rational.
Fundamentals drive market activity, but investor sentiment can override fundamentals, pushing markets, or individual stocks or sectors of the market, in unexpected directions.
Market Psychology: Theories and Trading
Some types of trading and or investing approaches do not rely on fundamental analysis to assess opportunities. For instance, technical analysts use trends, patterns and other indicators to assess the market's current psychological state in order to predict whether the market is heading in an upward or downward direction. Trend-following quantitative trading strategies employed by hedge funds are an example of investing techniques that rely in part on taking advantage of shifts in market psychology, exploiting signals, to generate profits.
Studies have looked at the impact of market psychology on performance and investment returns. Economist Amos Tversky and psychologist and Nobel prizewinner Daniel Kahneman were the first to challenge both accepted economic and stock market performance theories that humans are rational decision-makers and that financial markets reflect publicly available and relevant information in prices (so that it is impossible to beat the market). In doing so, they pioneered the field of behavioral economics (also called behavioral finance). Since then, their published theories and studies on systematic errors in human decision-making stemming from cognitive biases including loss aversion, recency bias, and anchoring have come to be widely accepted and applied to investing, trading, and portfolio management strategies.