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.

BREAKING DOWN '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.

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 accepted both economic and stock market performance theories that humans were 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.

  1. Loss Psychology

    Loss psychology is about the emotional side of investing and ...
  2. Daniel Kahneman

    Daniel Kahneman is a professor emeritus of psychology and public ...
  3. Rational Choice Theory

    Rational choice theory is an economic principle that assumes ...
  4. Paradox of Rationality

    The paradox of rationality is the empirical observation that ...
  5. Behavioral Funds

    Behavioral funds are a category of mutual funds that use behavioral ...
  6. Decision Theory

    Decision theory is an interdisciplinary approach to determine ...
Related Articles
  1. Investing

    Seven Controversial Investing Theories

    Find out information about seven controversial investing theories that attempt to explain and influence the market as well as the actions of investors.
  2. Investing

    An Introduction to Behavioral Finance

    Curious about how emotions and biases affect the market? Find some useful insight here.
  3. Trading

    An Introduction to Consensus Indicators

    Learn how the herd is almost always wrong, or at least late in jumping on the bandwagon.
  4. Investing

    4 Behavioral Biases And How To Avoid Them

    Here are four common common behavioral biases for traders and how to minimize their effects on your portoflio.
  5. Investing

    Behavioral Finance and the 4 Stages of Bull and Bear Markets

    Step into the psychological aspect of investing. Just as investor behavior can be irrational during bull markets, bear market cycles may also exemplify unique cognitive biases.
  6. Financial Advisor

    8 Common Biases That Impact Investment Decisions

    Behavioral biases hit us all as investors and can vary depending upon our investor personality type.
  7. Financial Advisor

    Behavioral Finance: How Bias Can Hurt Investing

    Here are three cognitive biases from behavioral finance that investors would do well to be aware of to avoid making poor investment decisions.
  8. Investing

    9 Cognitive Biases That Affect Your Business

    Human beings often act irrationally when it comes to business decisions. Behavioral finance explains the difference between what we should do and what we do.
  9. Trading

    How Market Psychology Drives Technical Indicators

    The tenets of market psychology underlie each and every charting tool.
  1. What's the difference between agency theory and stakeholder theory?

    Agency theory and stakeholder theory are both used to understand and explain various types of relationships and challenges ... Read Answer >>
  2. Has the Efficient Market Hypothesis been proven correct or incorrect?

    Explore the efficient market hypothesis and understand the extent to which this theory and its conclusions are correct or ... Read Answer >>
  3. What is the chaos theory?

    The chaos theory is a complicated and disputed mathematical theory that seeks to explain the effect of seemingly insignificant ... Read Answer >>
  4. Which financial principles help companies choose capital structure?

    The static trade-off theory and the pecking order theory are two financial principles that help a company choose its capital ... Read Answer >>
Trading Center