Risks due To Market Psychology

Market psychology is a huge factor in price moves, because the price is based on expectations. Whether this is due to hoped-for improvements or continued earnings or to wanting to sell for a quick profit after a price rise. There are well known sayings in the market such as "the time to buy is when there is blood in the streets" and

"when all the experts expect prices to continue going up indefinitely, sell immediately". There are indicators which track market sentiment, in an attempt to take advantage of these sayings..

The well known phenomenon of market bubbles is also due to market psychology. Here one need look no further than the dot com bubble on NASDAQ. But there have been bubbles all over the world and throughout history.

Contrarian investors attempt to take advantage of this phenomenon, but one can be trapped here, too. remember "no price is so high that it cannot go higher, or so low that it cannot drop further, unless it is already 0". So if a contrarian shorts a stock because it has been rising for a long time, it may continue rising. Equally, a stock that has dropped a long way may still go down further.

The problem with market psychology is that it is mass psychology, and we are all part of the mass. In fact, it often happens that somebody might resist buying because he thinks a stock has risen too much, watches the stock continue rising then eventually buys - only to have the stock start dropping. Someone buys at the high or sells at the low.

It is extraordinarily difficult to resist being caught up in the mass psychology of markets. Even Warren Buffett admits to having held on to stocks when in retrospect he should have sold, the price at the height of a particular stock not being justified even by the most optimistic estimates of future earnings.

The two biggest factors are fear and greed. Greed caused Warren Buffett to hold on when he should have sold. Fear makes you nervous to enter the market at the bottom. Greed makes you buy at the top.

Remember, no one went bankrupt by taking profits. But plenty have seen profits vanish when they held on too long. No one lost anything except potential profits by not being in a stock when it rises. Better to wait for another opportunity, or learn to short stocks.

There are people who rode some dot com stocks to their highs then shorted them and rode them all the way down to 0.