There is often little logic in the movements of the market. Indeed, this is because stocks move at the whim of human beings, who can often be illogical themselves and driven by emotions. With as many technical and fundamental analyses that are done on equities, their most important influence is perhaps psychology.
Psychology is a vital, but under-appreciated element of stock trading. This may be because most analysts are more mathematically oriented. But, those who ignore the human and social aspect of the market are making a serious mistake.
There are four different emotions that cause most investor’s decisions. They are greed, fear, hope and regret.
Greed is the desire for money and wealth. When a trader experiences greed, they are only able to think about how much money they have made from a stock, and how much more they can make by keeping their position. The problem is that a profit is not realized until after a position is closed. Until this happens, a trader only has the potential for profit. Greed can lead to an investor holding a stock for longer than they should, hoping to make more money… until it plummets.
Fear, which is probably the strongest of all human emotions, causes a trader to sell a position regardless of its price. Unlike other emotions, fear is a survival response. The Dow Jones Industrial Average (DJIA) in the U.S. took from 1983 until 2007 (24 years) to grow from 1,000 to 14,200, but it only took two years to lose 50% of its value (2007-2009). That’s the power of fear.
Fear can be beneficial if it gets you out of a poor trade. But it is dangerous if it causes investors to not buy a stock that would otherwise be profitable.
Hope, a feeling of expectation and desire, might be the most dangerous emotion and along with greed, is what keeps a trader in an unprofitable position. When a stock that has lost money is going up, investors will often stay in the “hope” of recouping past losses. This is dangerous because the market will do what it does, regardless of an investor’s wishes.
Regret is a feeling of disappointment over something that has happened, and can cause a loss of focus. While it is natural to regret making a bad trade or missing a good one, an investor must simply learn from what went wrong and move on to the next opportunity.
For those who can learn to predict other’s emotions and master their own, knowledge of market psychology can be a very powerful tool. While some inexperienced investors may wonder whether to buy or sell a stock, you should ask instead, “What are others doing?”