Let’s dive deeper into the psychology of the markets, trying to understand what motivates investors and traders to act the way they do. One of the most important concepts of behavioural finance is that investors’ behaviours repeat time and time again. There are no guarantees, of course, and every situation will be a little different, but humans can be fairly predictable. We typically fear the worst just before things get better and we expect things will always be this good just before they get worse.
Here are a few of the most impactful key ideas:
1. Confirmation Bias
Confirmation bias occurs when you focus only on the information that confirms your beliefs. People do this with their political beliefs all the time, and the media plays into it by exclusively giving them information that aligns with their point of view.
In the markets, an investor may believe that a stock is a great buy because they see the company’s products everywhere, which may cause them to ignore the fact that the stock has been in a downtrend all year. Despite the market signalling that things are not great for the company, the investor buys the stock anyway.
Overconfidence is a common trait among humans. In the markets, when things are going well, investors often confuse a bull market with their own genius and think they’ll know when to get out. Of course, it doesn’t work out that way. Just like the friend who believed he was a great driver despite multiple accidents, investors can overestimate their abilities and ignore warning signs in the market.
3. The Herd Effect
The herd effect is something we’ve all experienced in various aspects of life. How many times have you been looking for a place to eat and walked past an empty restaurant to wait at a crowded one? Similarly, in investing, people often pile into popular trends because it seems like everyone else is doing it. This behaviour was evident in the dot-com bubble, the crypto craze, cannabis stocks, and meme stocks.
Being aware of these concepts can help you question your own decision making and ensure that you’re thinking critically about each buy and sell.
Technical analysis is the visual representation of investors’ emotions. The more aware you are of those emotions and behaviours and how to interpret them, the better investor you are going to be. Always remember to keep your emotions in check, watch out for confirmation bias, be cautious of overconfidence, and avoid blindly following the crowd. Understanding investor psychology can be a powerful tool in your investment arsenal, helping you make more informed and rational decisions in the world of finance.