Explained: Psychology of Financial Markets
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.
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 behaviour 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.
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.
PSYCHOLOGY AND CRYPTOCURRENCY
Psychology has a huge effect not only on how we use cryptocurrency but the rate of its adoption in the general marketplace. Understanding these factors can give you an edge in cryptocurrency trading.
While the psychology of traditional investments is well-known and has been comprehensively studied, there are many key differences in the emerging cryptocurrency trading. Still more psychological barriers exist for a widespread crypto adoption in the marketplace. We’ll take a look at some of these different factors, starting with investment in general.
One of the number-one pieces of investing advice you’ll ever hear is ‘don’t invest based on emotion.’ You’ve probably heard that before if you even have a passing interest in investment, but you may not have stopped to think about why.
Statistics show that the majority of people trading financial instruments in any given year lose money. But what separates them from those who consistently gain? The answer is complicated, but can be understood when you examine the psychology that affects our decision-making processes.
Fear is one of the most powerful motivating factors in the human condition. Fear of (further) loss is what causes people to sell off during a market downturn or correction. How can you counteract that fear? One way is by not over-leveraging yourself.
That means, only trading, say, 10% of your assets at a time makes you less vulnerable to acting out of fear than if you have 50% or especially 100% of your assets tied up in one single investment.
Investing money that you can’t afford to lose also causes stress and fear to control your decision-making. Even with the best information available and a very sharp mind, you’re not going to make good decisions if you make an investment with your next month’s rent money.
Most consider investment to be a long-term strategy, but many let fear dictate their actions and sell off at the slightest hint of a downturn. Even day-traders follow strict guidelines to take emotions like fear out of the equation.
Another emotion to avoid is attachment. If a stock or asset is performing well, it can sometimes lead you to hold onto it longer than you should. This all depends on your goals, and if that is to make a profit, then you should not get enamoured by a high value.
Remember, the value of stocks does not equate to cash. Set realistic earning targets and cash out your investments when the price meet targets. Then, take a percentage of that and reinvest if you want — but you will protect the majority of your gains.
The psychology of investing and trading financial instruments is a very complex and tricky thing to navigate. Adding cryptocurrency to the mix adds a new layer to these same concepts.
One of the most important things to remember is that you need to protect the bulk of your wealth. Having all your wealth tied up in a volatile investment will lead to decisions ruled by fear.
Focusing on the goal of a crypto-issuing company, and how it is working to achieve that goal are better ways to frame your thinking. If their goal is to build wealth, or just to see cryptocurrency succeed in disrupting the market, the way they achieve that should be the same.