Market Psychology: What is it, Predictions, and FAQ

What Is Market Psychology?

Market psychology refers to the prevailing behaviors and aggregate sentiment of market actors at any point in time. The term is often used by the financial media and analysts to explain market movement that may not be explained by other metrics, such as fundamentals.

Market psychology describes the overall behavior of a market based on emotional and cognitive factors on net and should not be confused with trader psychology, which refers to the same factors but that affect just a single individual.

Key Takeaways

  • Market psychology is the consensus sentiment of the market as a whole based on the aggregate of individual market participants.
  • Greed, fear, anxiety, 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 potentially irrational impact of market psychology.

Understanding Market Psychology

Market psychology is considered 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.

Greed, fear, expectations, and euphoria 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 General 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 (EMH), is criticized as not accounting adequately for market psychology. 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 methods of stock-picking used by the professionals, and only one of them pays much attention to market psychology.

  1. 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.
  2. 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. Their goal is to identify and exploit discrepancies between an instrument's fundamentals and the market's perception of it to generate profits.

Market Psychology Research

Studies have examined 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.

Frequently Asked Questions

What Does Market Psychology Teach Us?

Because market actors are human beings, markets as an aggregate of human choice can display herding behavior and other irrational tendencies such as panic selling and irrational exuberance that leads to asset price bubbles. By acknowledging the existence of market psychology, we can understand that markets are not always efficient or rational.

How Can People Use Market Psychology to Their Advantage?

By doing your own research, you can identify when market psychology—emotions like fear or greed—result in oversold or overbought conditions. You can then make contrarian trades—buying when others are overselling and selling when others are overbuying. Research can also help you jump on trends early but not chase trends after they've already gone past their fundamentals.

In Which Markets Is Market Psychology Present?

Market psychology applies to all asset classes, from stocks and bonds to forex, interest rates, and cryptocurrencies.

How Can One Gauge Market Psychology?

There are several indicators of market sentiment that one can look at, such as the VIX, which measures the implicit level of fear or greed in the market. Technical analysis tools can also be used to reveal sentiment in a market based on historical price action and volume.

Article Sources
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  1. John Maynard Keynes. "The General Theory of Employment, Interest, and Money," Page 144. Atlantic, 2008.

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