psychological aspects of market
What is market psychology?
The principles of market psychology underpin each technical indicator, so a good understanding of crowd behaviour is essential to understanding the fundamentals of certain technical indicators. Market psychology is difficult to predict, but several reliable indicators allow traders and investors to better estimate directional changes based on changing sentiment.
Here we take a look at several technical indicators which are determined by the psychology of the market.
KEY POINTS TO REMEMBER
- Market psychology is the consensus sentiment of the market as a whole based on all of the market participants.
Greed, fear, anxiety and excitement can all contribute to market psychology.
The conventional financial theory assumed that prices were always based on rational considerations and did not explain the potentially irrational impact of market psychology.
Market Psychology Prediction
There are, in general, two methods of stock selection commonly used by traders, and only one of them pays special attention to market psychology.
Fundamental analysis seeks to choose winning stocks by analyzing a company’s financial data in the context of its industry. Market psychology has little place in this digital analysis.
Technical analysis focuses on trends, patterns and other indicators that cause a stock’s price to go up or down. One of those factors is market psychology.
The quantitative trend following trading strategies employed by hedge funds is an example of investing techniques that rely in part on exploiting changes in market psychology. Their objective is to identify and exploit the gaps between the fundamentals of an instrument and the perception of it in the market to generate profits.
Understanding Market Psychology
Market psychology is viewed as a powerful force and may or may not be justified by fundamental details or events. For example, if investors suddenly lose confidence in the health of the economy and decide to opt out of buying stocks, the indexes that track overall market prices will fall. The prices of individual stocks will decline with them, regardless of the financial performance of the companies that initiated those actions.
Greed, fear, expectations and euphoria are all factors that contribute to the general psychology of the market. markets, it is well documented.
These changes in market behaviour are often referred to as settling animal spirits. The term 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 impulse to action rather than inaction.”
Conventional financial theory, namely the Efficient Market Hypothesis (EMH), is criticized for not considering market psychology sufficiently. It describes a world in which all market players behave rationally and ignores the market’s emotional side. But market psychology can lead to an unexpected outcome that cannot be predicted by studying the fundamentals. In other words, the theories of market psychology contradict the belief that markets are rational.
Fundamentals drive stock performance, but market psychology can trump fundamentals, pushing stock prices in an unexpected direction.
Market Psychology Research
Studies have examined the impact of market psychology on the performance and returns of investments. Economist Amos Tversky and Nobel Prize-winning psychologist Daniel Kahneman were the first to question the efficient market theory of the conventional market.
That is, they did not accept the idea that humans in financial markets will always make rational decisions based on publicly available and relevant price information.
By refuting this notion, they paved the way for the field of behavioural economics. Their theories and studies focus on identifying systematic errors in human decision-making that result from cognitive biases such as loss aversion, recent biases, and anchoring. Their work has been widely accepted and applied to investment, trading and portfolio management strategies.
