Market Psychology: What Is It and Predictions

What Is Market Psychology?

Market psychology refers to the prevailing behaviors and aggregate sentiment of market actors at any point in time. The term is often used by the financial media and analysts to explain market movement that may not be explained by other metrics, such as fundamentals.

Market psychology describes the overall behavior of a market based on emotional and cognitive factors on net and should not be confused with trader psychology, which refers to the same factors but that affect just a single individual.

Understanding Market Psychology

Market psychology is considered a powerful force and may or may not be justified by any particular fundamentals or events. For instance, if investors suddenly lose confidence in the health of the economy and decide to pull back on buying stocks, the indexes that track overall market prices will fall. The prices of individual stocks will fall along with them, regardless of the financial performance of the companies behind those stocks.

Greed, fear, expectations, and euphoria are all factors that contribute to markets’ overall market psychology. The ability of these states of mind to trigger periodic “risk-on” and risk-off”—in other words, boom and bust cycles in financial markets—is well documented. These emotions can be further fueled by the constant availability of news and information, known as the CNN effect.

These shifts in market behavior are often referred to as animal spirits taking hold. The expression was coined by John Maynard Keynes in his 1936 book, "The General Theory of Employment, Interest and Money." Writing after the Great Depression, he described animal spirits as a “spontaneous urge to action rather than inaction.”

Conventional financial theory, namely the efficient market hypothesis (EMH), is criticized as not accounting adequately for market psychology. It describes a world in which all the players in the market behave rationally and fail to account for the emotional aspect of the market. However, market psychology can lead to an unexpected outcome that can't be predicted by studying the fundamentals. In other words, theories of market psychology are at odds with the belief that markets are rational.

Predicting Market Psychology

There are, broadly, two prevailing methods of stock-picking used by the professionals, and only one of them pays much attention to market psychology.

1. Fundamental analysis seeks to choose winning stocks by analyzing the company's financials within the context of its industry. Market psychology has little place in this number-crunching.
2. Technical analysis focuses on the trends, patterns, and other indicators that drive the prices of a stock higher or lower. Market psychology is one of those drivers.

The trend-following quantitative trading strategies employed by hedge funds are an example of investing techniques that rely in part on taking advantage of shifts in market psychology. Their goal is to identify and exploit discrepancies between an instrument's fundamentals and the market's perception of it to generate profits.

Market Psychology Research

Studies have examined the impact of market psychology on performance and investment returns. Economist Amos Tversky and Nobel prizewinning psychologist Daniel Kahneman were the first to challenge the conventional market theory of the efficient market. That is, they did not accept the notion that humans in the financial markets will always make rational decisions based on publicly available and relevant information in prices.

In refuting that notion, they pioneered the field of behavioral economics. Their theories and studies focus on identifying systematic errors in human decision-making that stem from cognitive biases such as loss aversion, recency bias, and anchoring. Their work has been widely accepted and applied to investing, trading, and portfolio management strategies.

The Bottom Line

Market psychology is the study of herd behavior and sentiment among economic actors, such as businesses, traders, or consumers. By studying the prevalence of greed, fear, or euphoria in the market, skilled traders can forecast future price movements and fluctuations in supply and demand.