Role of psychology in investing

Author: Valarmurugan
Published Date: April 10, 2019

Psychology in Investing

It is very difficult for investors to resist the temptation to act frequently in markets. But frequent activity doesn’t guarantee any extra returns for investors. The very basic nature of the market can be attributed to the process of pendulum swing. The pendulum swings from one end to the other end and it spends very little time in its equilibrium state. Likewise, markets also swing between extreme pessimism (undervaluation) to extreme optimism (overvaluation) and markets also spends very little time in being in an equilibrium state (fair valuation). In order to make money in markets, it is necessary to identify these swings of the markets and act accordingly. The pendulum swing in the market can be attributed to the pendulum swing in the psychology of the investor.

Investor’s Psychology – Pendulum Swing

Investors emotions swing between greed and fear in markets. During good times, investors feel positive and become greedy therefore, these greedy investors would bid up the stock prices to sky level. Whereas during bad times, investors feel completely negative and very fearful, so they sell all their stocks making the stock prices to reach a deep bottom.

An intelligent investor is, who clearly understand the psychology of the market and buy stocks when everyone is selling and sell when everyone is buying.

Fear and greed may be the two main emotions in the market but there is another one emotion which largely dominates the sentiment of the market, that is Fear of missing out.

Fear Of Missing Out

During the bull market, when the stock is moving higher every day then, many investors think that “if we miss this rally in the stock market, we wouldn’t get any other opportunity”. For example, in 2017 the prices of Bitcoin were moving higher day by day and many people thought that, if they miss the rally in bitcoin prices, they would be left behind, so most of the people were suffering from the emotion of “fear of missing out” and so bought bitcoin even when it was trading at very high prices. Now in 2019, we can clearly see, what had happened to the bitcoin prices, bitcoin prices have fallen more than 80% from its all-time high.

Investors have to be very careful about this emotion because our temptation to act in the stock market is largely influenced by other investors. Therefore, the most important thing for the investor to keep in mind is the – awareness of pendulum.

Howard Marks in his book “the most important thing” describes beautifully the greed/fear cycle. Greed/fear cycles cause bull and bear markets.

He goes on by saying that, there are three stages in the bull market

  1. The first stage is when a few forward-looking people begin to believe things will get better.

  2. The second stage is when most investors realize improvements is actually taking place.

  3. The third stage is when everyone concludes that, the things will get better forever.

The first stage is where the smart money comes into the market and the second stage is where much institutional money comes into play and in the third stage is the place where most of the retail investors come into the market and get stuck in the markets.

Most of the time, bull and bear markets are formed not because of earnings growth in the companies but rather bull and bear markets are formed majorly through the emotions of the investors.

Even if the companies are not doing well and if the mood of investors is bullish means, the share prices of the companies which are not able to make profits will also be moving in upside direction.

It is very necessary for an investor to determine if the shares prices are moving due to emotions or due to the fundamental growth of the company.

One of the ways by which investors can avoid their emotion trap is by detachment towards the markets.

All the great investors have got great detachment towards the markets because they are masters of their emotions.

It is impossible to be very successful in investing if we have an attachment to our investments. Investors should be able to handle their emotions firmly to succeed in the game of investing.

Do you wish to invest in stock market?

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