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Understanding Your Own Emotions
- By Pauline Yong, author of “I Love Stocks”
Studies by economists and psychologists have found that investors are most
influenced by recent events – market news, political events, earnings reports – and
ignore long term investment and economic fundamentals. Furthermore, with
traders using computers to buy and sell stocks and receive information, news
affecting investor psychology travel faster than ever before. As a result, if a
movement starts in one direction, it tends to pick up more and more investors with
time and momentum. It’s like a domino effect!
Successful investors usually do a lot of research and they have an investment plan
before they invest. Although a good research does not guarantee the performance
of any particular investment, but it does help to avoid more of the bad ones.
Successful investors even develop contingency plans for what to do when a special
investment or situation comes along that requires a little quicker action. The goal is
to not let your emotions or too much information rule your investment plan.
The study of market psychology can help investors to identify the common mental
mistakes that repeatedly made by them. Common mistakes sometimes lead people
to incorrectly process new information about a company and in turn, misjudge a
stock’s true value. In general, the stock market preys on fear and greed, and it’s not
designed to reward the masses. In other words, the stock market acts on fear,
speculation – and herd mentality.
Now, let’s go through some of the emotions and mental errors that cause stock
prices to move wildly.
Herd Mentality
Herd mentality refers to an irrational collective buying and selling for no strong
reason. It could be a surprise rally which is uncalled for or a panic sell-off that defies
the logic. For example, if a company is expected to pay a big dividend, its stock price
will rise - but if that company then pays a less-than-expected (but substantial)
dividend, the price will fall. The company is still profitable, but it's not living up to
expectations, hence it faces the selling pressure. Once the selling pressure is initiated
by a group of investors, other players in the market will follow suit.
The rationale behind this is: we tend to feel comfortable doing things together. One
can even see this trait in other animals such as a flock of birds or a school of fish.
They seem to follow a leader.
The way to profit from this phenomenon is to resist the herd mentality and try to be
a leader. In any crowd, or group behaviour situation, the ones that lead are the ones
that draw all the benefits, while the ones that follow blindly are the ones that take all
the risks.
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