Market psychology defined as the popular sentiment of the investors who actively participate in the market at any point in time. These sentiments, many times, drive the market performance to a certain direction which at odds with the fundamentals analysis.
For example, if an investor loses confidence, suddenly, then he or she decides to pull back, then the market may fall.
Defining Market Psychology
There are various factors that significantly affect the investing sentiment. They range from investors’ fear, greed, circumstances, and also expectations. In other words, these states of mind can boom and bust the cycles in the financial markets.
According to Investopedia, people usually use the term ‘animal spirits’ to refer to these shifts in market behavior. That term comes from the description of John Maynard Keynes, in his book published in 1936.
In the efficient market hypothesis (EMH), we know that investors will make decisions rationally. EMH is one of the conventional financial theory. But, that theory does not consider the emotional aspect of the market.
That aspect sometimes, guide us to unexpected outcomes. Simply looking at the fundamentals will not be enough for investors to predict that situation. In summary, this market psychology theory is contrary to the belief that markets are rational.
The Effect on the Trades
There have been various studies that focus on the market psychology effect on investment performance and return. Daniel Kahneman (a psychologist and Nobel prize winner) and Amos Tversky (an economist) were the first people who found that human is not always rational decision-makers.
Besides, they also challenge the theory that says financial markets reflect publicly available and relevant information about prices. There are more studies on the effect of market psychology on the investors’ performance and returns since then.
To avoid these risks, there are some trading or investment strategies that do not rely on fundamental analysis to know its opportunities. The example of that approaches is the one that is done by technical analysts.
They use trends, patterns, or other trading indicators to examine the market’s current psychology situation to predict if it goes upward or downward.