The psychology of markets

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03/09/2020
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Market movements of late have been, to put it mildly, quite extraordinary. The NASDAQ, with its technology behemoths such as Apple and Tesla, continues to fly higher in stark contrast to the economic disaster that we are watching unfold. Apple has now become the first two trillion-dollar company after only reaching the prize of the first one trillion-dollar company in 2018 (The Verge).  And the Tesla share price and net worth of its eccentric founder Elon Musk, much like his space rockets, appear to defy gravity.

So, what is driving some of these moves, like with many market events there are often a multitude of factors at play but one which is often overlooked as having a significant impact is that of investor psychology.

The fear of missing out

The emotions that drive investors are mainly from fear and greed to denial and capitulation, the below table shows the range of emotions through which many investors will travel during a market cycle. These emotions can be detrimental to investment performance, causing decisions to be made at the wrong moment. For example, capitulation and despondency shown on the chart below could provide a great entry point, but it is at a time when investors for emotional reasons may be least willing to commit capital, this is where the famous adage of Warren Buffett can be a useful guide, “be fearful when others are greedy and greedy when others are fearful”. In the recent stock market rally, many ascribed a portion of this move to the fear of missing out. Prior to COVID-19 we witnessed the longest bull rally in history. Many retail investors had watched from the side lines as others made large returns and had waited for an opportunity to join the party and ride this market higher. They were however, left exacerbated at the length of this bull run. COVID-19 sent the market rapidly lower initially, but we quickly witnessed a rally, investors would have felt an immense fear of not missing out again as they watched the market recover prompting them to commit capital, it is these kind of emotions that professional investors must keep in check.

 

Investor emotion cycle image

 

Herd mentality

Watching the Coronavirus briefings over the last few months, many will be familiar with Professor Chris Whitty and his reference to herd immunity in defeating the pandemic. But an idea that should also be familiar is that of herd mentality. This is the idea that humans are inclined to follow what they perceive others around them to be doing, in contrast to what their own understanding and analysis may be telling them. Again, the fear of missing out on a profitable investment is at play here. Investors following others into an investment purely based on the idea that they do not want to miss out on the incredible gains that they are witnessing others make. This in turn drives the share price higher and higher until a point where fundamentals once again prevail, and rationality resumes control and price quickly reverts. This can be described as a bubble.

A warning from stock splits

At times investor psychology can make some market movements seem illogical. Facts become of no importance and the emotion of greed acts as a strong pull to draw investors’ money in. Stock splits are a good example of how investor psychology can have an impact on markets. Both Apple and Tesla recently engaged in a stock split, and if the aim of this split was to draw in more retail investors then the plan worked, with both companies surpassing record highs the day after the corporate actions went into effect. Many commentators now believe we could see other technology businesses looking to split stock on the back of Apple and Tesla’s success. After closing at over $2,000 a share on 28 July, Tesla’s share price surged to nearly $500 following the 5-1 split with 115 million shares changing hands (Bloomberg). But stock splits shouldn’t drive share prices higher, they must be supported by underlying fundamentals. History teaches us important lessons about stock splits driving markets higher with many companies implementing stock splits in the run up to the dotcom crash of 2000.

What we should conclude from this is that humans are emotional beings, but these emotions can often act against us as investors. It is for this reason that it is important for investors to be aware of how big an element investor psychology can play in driving market movements. Indeed, as we see markets and companies continuing to make record highs, understanding everything that is driving these moves will be more important than ever. Do not underestimate the power of psychology in markets.

 

 

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The value of an investment may fall as well as rise. You may get back less than the amount invested.

The information contained does not constitute investment advice. It is not intended to state, indicate or imply that current or past results are indicative of future results or expectations. Full advice should be taken to evaluate the risks, consequences and suitability of any prospective investment. Opinions provided are subject to change in the future as they may be influenced by changes in regulation or market conditions. Where the opinions of third parties are offered, these may not necessarily reflect those of Rowan Dartington.

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