Uncovering The Role Of Mass Psychology In Stock Market Fluctuations
If you speak to any stock market expert, they would advise you to make investment decisions based on knowledge. That is a very rational approach towards investing. However, investment decisions are not just based on rationality. Daniel Kahneman, a Nobel laureate, and his colleague challenged conventional wisdom. They argue that human biases tend to skew the rational approach towards investing. That gave birth to an entirely new field of behavioural economics. Kahneman died recently in 2024, but his work with his fellow economists will stay for years to come to explain the mass psychology in the stock market. Here is one interpretation of the behavioural aspect of investing:
Herd mentality
A lot of people follow the trend. They buy shares when everyone is buying and sell when everyone is selling. A collective emotion induces an action that leads to the stock market euphoria or a slump. It comes from a basic instinct of sticking together for survival. A lack of adequate knowledge of the stock market and understanding of financial market cycles is the primary reason for following the herd. If you know that financial markets go through cycles, you will not rush to buy or sell in a panic.
Loss aversion
The fear of loss is a significant reason people avoid risks. Stock markets are rewarding in the long term. However, there is short-term volatility. That could be due to the intense trading activity, the business’s financial performance or many other reasons. Many people jump into the stock market trading without doing adequate homework. When they suffer losses, they stop operating their account. Many trading accounts are dormant and do not see any trading activity due to loss aversion. Your stockbroker can guide you to your first trade and subsequent trading activity if you seek their help. That applies only to a full-service securities firm. They produce regular research to help you navigate the market.
Recency bias
You worry about a recent development and do not act on a potential opportunity. For example, you could have suffered a notional loss in your investment. A professional may advise you to buy low and sell at a higher price later. However, you may not want to do that due to your apprehensions about your recent loss. There could be other reasons, too. Recent developments in a company could bring the share price down. However, on many occasions, companies with solid fundamentals are viewed as buying opportunities in such situations. You could give more importance to recent events.
Panic selling
As stock markets go through cycles, there are boom and bust phases. Many of you tend to run to the door when panic sets in. Legendary American investor who created billions of dollars of wealth for himself and his stakeholders often used to say that you need to get greedy when others are fearful. For an investor who buys and holds investments, you see such downturns as an opportunity. If others are panicking and selling quality companies, you may want to step back and analyse the situation. The best-managed companies have an efficient way of returning from crises. Selling in panic could be counter-productive.
Irrational exuberance
That is the opposition to panic selling. In a bull market, everyone keeps buying shares to make profits at a higher level. That is so much that the trading activity could drive the market situation towards valuations not backed by fundamentals or rationality; however, you must be cautious when everyone else is euphoric. You need to compare the present situation with the previous bull markets. Identify things that are similar and different in the bull markets. Your stockbroker can help you understand the market situation.
Conclusion
Emotions can get over rationality during market cycles. You must invest in knowledge to support your actions. During the bull run, professional help in such a situation will allow you to differentiate between the good and the bad in the stock market. You can then arrive at a decision keeping your long-term goals in mind.
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