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Psychology and Behavioural Finance to Understand Stock Market: A Lesson for Investors

Submitted by admin on March 21st, 2024

The stock market is not a rocket science. To achieve success in this field, the way you behave is more important than how much you know. Stock prices, charts, balance sheets, and management commentaries are open to all but only a few outsmart others. What makes such a difference? Psychology and behavioral pattern!

Most often, it happens because of our blind spots and existing beliefs that exist without our being aware of their existence. In this post, we will discuss a few psychological indicators that are the actual driving forces behind the success of a successful stock market investor.

VIX: This index projects volatility, presenting the range and speed of the changing prices over a period. Stock market investors can correctly predict market sentiments based on VIX, especially to guess the fear factor in market participants.

Fear & Greed Index: This index is a projection of market sentiments to measure investors’ emotions and psychology. It offers an insight into market investors’ psyche to analyze if they are driven by fear, greed, or a mix of both at a given period.

Put-Call Ratio: This ratio helps investors guess the overall market sentiment because it can imply a possible reversal in the market trend.

In the short run, the market behaves like a voting machine. Still, as time progresses, it tends to make us believe the group’s thoughts, leading to different types of biases like “collective rationalization”, “an illusion of indestructibility” and “turning a blind eye to pitfalls”.

Behavioral science theory suggests that different cognitive biases can influence an individual’s investment decision. With knowledge of the most common biases, you can avoid them and make pragmatic decisions. “What you avoid” sometimes makes more sense than “what you do”, especially when it comes to the fruition of your investment.

Herd Mentality: Humans tend to jump onto the bandwagon. People often follow others while making a decision. The flip side of such behavior is it can create asset bubbles, a condition characterized by rapidly rising stock prices that ultimately nosedive, collapsing the market. It happens when a large number of investors sell off their shares.  

Overconfidence: Most people overestimate their abilities and eligibility. When you feel overconfident in having more knowledge about a specific stock or the entire market, you are likely to have a higher risk appetite.

Consequently, you will feel tempted to predict the right time to buy or sell stocks, overinvest in riskier stocks, and many other things that could prove disastrous for your financial life.

Loss Aversion: The pain of loss is felt more than the happiness after a big win. Even if your wins are more than your losses, you will not feel euphoric; such is the psychology of human beings. As a result, investors often cringe at the thought of selling the stocks to avoid being hurt by a loss. They can also sell off their stocks earlier to avoid loss.

This explains why investors with a strong bias favoring loss aversion hold on to conservative portfolios, underperforming the market.