What Is Market Psychology?

Market psychology is the prevailing sentiment of financial market buyers and sellers at any point in time. The term is often used by the financial media and analysts to explain a sudden movement up or down in the markets.

Market psychology is considered to be a powerful force and may or may not be justified by any particular fundamentals or events.

For instance, if investors suddenly lose confidence in the health of the economy and decide to pull back on buying stocks, the indexes that track overall market prices will fall. The prices of individual stocks will fall along with them, regardless of the financial performance of the companies behind those stocks.

Key Takeaways

  • Market psychology is the mood of the market participants at any given point in time.
  • Greed, fear, and excitement can all contribute to market psychology.
  • Conventional financial theory assumed that prices were always based on rational considerations and failed to account for the impact of market psychology.

Understanding Market Psychology

Greed, fear, expectations, and circumstances are all factors that contribute to markets’ overall market psychology. 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.

These shifts in market behavior are often referred to as animal spirits taking hold. The expression was coined by John Maynard Keynes in his 1936 book, The Theory of Employment, Interest, and Money. Writing after the Great Depression, he described animal spirits as a “spontaneous urge to action rather than inaction.”

Conventional financial theory, namely the efficient market hypothesis, is criticized as not accounting adequately for market psychology. That is, it describes a world in which all the players in the market behave rationally and fails to account for the emotional aspect of the market. But market psychology can lead to an unexpected outcome that can't be predicted by studying the fundamentals.

In other words, theories of market psychology are at odds with the belief that markets are rational.

Fundamentals drive stock performance, but market psychology can override the fundamentals, pushing a stock's price in an unexpected direction.

Predicting Market Psychology

There are, broadly, two prevailing ways of stock-picking used by the professionals, and only one of them pays much attention to market psychology.

Fundamental analysis seeks to choose winning stocks by analyzing the company's financials within the context of its industry. Market psychology has little place in this number-crunching.

Technical analysis focuses on the trends, patterns, and other indicators that drive the prices of a stock higher or lower. Market psychology is one of those drivers.

The 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. They exploit signals to generate profits.

Market Psychology Studies

There have been studies on the impact of market psychology on performance and investment returns. Economist Amos Tversky and Nobel prizewinning psychologist Daniel Kahneman were the first to challenge the conventional market theory of the efficient market. That is, they did not accept the notion that humans in the financial markets will always make rational decisions based on publicly available and relevant information in prices.

In refuting that notion, they pioneered the field of behavioral economics. Their theories and studies focus on identifying systematic errors in human decision-making that stem from cognitive biases such as loss aversion, recency bias, and anchoring. Their work has been widely accepted and applied to investing, trading, and portfolio management strategies.