What is the main cause of stock market price fluctuations? Where prices come from? Are market efficient? How can you position yourself to take advantage of stock market movements?
Take a look at any financial chart of your choice, any security of any asset class, and ask yourself what are the similarities with all the other securities.
There is one particular thing that they all have in common: price fluctuations.
As you noticed, prices are subject to wide fluctuations over time. In this article, we are going to look at one of the most important driver of stock market movements that hopefully will offer you a wider perspective on the investing approach that a successful investor should have.
Are markets efficient?
The efficient market theory states that prices reflect all the information available, therefore stocks always trade at their fair value and it is not possible to make excess returns.
This creates a relationship between risk and returns and since it should be impossible to outperform the market through stock picking, according to this theory, the only way to obtain higher returns is to purchase investments with a higher degree of risk.
This theory is particularly appealing because allows you to create mathematical models for portfolio optimization and use calculus to perform asset allocation. When you look at the reality though, you see that there is a ton of empirical evidence that financial markets are not really that efficient, or at least they can change idea quite rapidly as we saw in 2020.
One of the main reason is that stocks don’t reflect just fundamentals but have a future value component that is 100% subjective. This is why in certain situations it can happen that there are substantial deviations between the price and the fair value of securities.
Market prices are the result of the expectation of thousands of single individuals, each one different than the other, that are subject to numerous psychological biases.
This component is heavily influenced by the sentiment of investors and traders, a sentiment that changes dramatically over short periods of time.
Psychology studies investigated the interconnection between our feelings and our judgments. This results in an emotional pattern that occured many times in history and is the plot of every bubble and subsequent market crash.
Being aware of those dynamics can massively help you in your investing decisions and yor definition of risks and opportunities.
Investor Emotion Cycle
Everyone gets excited and confident when his investment decisions are performing well and gets disappointed when things are not going as expected.
In general, your emotional response changes depending on the conditions of the market.
This generates a wave of emotions that results in the investor emotional cycle, composed by all the different emotional stages that go together with the rise and fall of our investments.
This chart describes all the different emotional states typically experienced by the majority of market participants:
Everything starts with a positive outlook towards the future that leads you to buy a stock.
Markets start moving up towards your expectations and a feeling of anticipation and hope arises inside, you start to see the success.
Market continues to go up, you are already earning and start to feel very confident of your investing decisions.
“You can’t miss opportunities”. Market grows, investments turn into quick and easy profits. Everyone wants to jump in: Who doesn’t want to make a ton of money risking as little as possible? The market is rising, isn’t it?
At this point, the financial risk is at it maximum, like the possible financial gain.
Things start to turn around, markets show the first signs of weakness but overall the sentiment for the long term is still bullish and you convince yourself that it is just a short correction.
The market correction is taking longer than you originally thought. Doubts start to arise and confidence in the long-term bull market turns into a strong hope for a short-term improvement.
At some point you have to compare your perception with the reality, maybe you haven’t been that smart. You would like to get out taking a small profit or even a small loss but you don’t act because you don’t know what to do, uncertainty is at its maximum.
All chances of making a profit are lost at this point, you are really concerned about your investment and you strongly hope for anything that will bring our positions back into gain territory.
This is the period with the most emotional impact, where you feel helpless and really don’t know what to do, feeling without any degree of control on the situation, on your investments and on markets.
You sell your position at any price because you reached your breaking point. In a certain way, you are happy to get out of the stock market in order to avoid bigger losses.
Your expectations have been disappointed, you got a strong loss from your investments, you feel bad and you don’t want to buy a stock ever again. This is the point of maximum financial opportunity for investors that are aware of what is going on and are willing to be contrarians.
This is the beginning of the aftermaths of the crash. You start thinking about what happened and ask yourself how you could have been that stupid. The key that makes the difference among investors here is if you start to look back to what happened and analyze what went wrong and start learning from from past mistakes.
Things start to gradually improve, the overall situation gets better and you realize that financial markets have cycles. You got some experience and you start to look around for new investing opportunities.
Markets are turning positive once again, you start to be faithful again and you convince yourself of your ability to invest your money. The cycle starts all over again.
Why does it happen?
As human beings we are emotional, therefore we are subject to some behavioural biases that originate situations like the investor emotional cycle. It is a very complex topic and psychological studies are continuously offering new insights.
Some points that could be useful to understand the cycle of investor’s emotions are that:
- We are wired to think exclusively
- We look for instant gratification
- We take part in herd behaviour
Stocks move up or down because we think exclusively. Investors are either convinced that stocks will go up, or down. That is why stocks usually go up with low volatility over a long period of time and then crash with high volatility during a very short time.
Putting a probabilistic expectation on what the stock market will do is something that very few investors do because it doesn’t come natural to humans. You have to ask yourself: am I under the influence of behavioural finance and am I thinking exclusively? Or, do I leave space to probabilities that allow me making rational decision over time?
Everyone seeks instant gratification. We all want to make money, as fast as we can, without risks. Financial media play their part here, their focus is always on extreme titles about short term movements while very few care about the bigger picture. That is why there are “hot stocks” chased by everybody and wide price movements following a particular piece of news.
We tend to conform to what the majority is doing. The point is that the majority is doing what everybody else is doing, without a particular direction. The result is that when markets go up, people buy more, if the market increases, investors rush to buy even more. This is true also for the opposite: when markets go down, people sell to avoid losses and the more prices fall the more investors sell.
You can see that even on a daily basis by noticing increasing trading volumes during the days when a stock has already increased a lot during the day because of the fear of missing out an opportunity and a wave of selling if the stock goes down because investors start to fear that it will fall even more. Everything happens while the underlying business doesn’t actually change.
How to take advantage of these dynamics?
By now, I hope that you recognize that human emotions regulate stock market buying and selling behavior and investing decisions are often driven by emotional reactions rather than rational calculations.
Being aware of those cycles and keeping your own emotions at check is one of the key element that will lead you to better investing decision. What stage are you in? I’d really like to know that in the comments. It is truly important to understand that because by understanding your feelings you can analyze your judgement.
Buying low and selling high is still one of the best strategies to build wealth and become a successful investor over the years (you want to arrive at the end of the marathon, don’t you?).
The truth is that the majority of people do exactly the opposite. This should help you to stop and think about it the next time that you hear about other’s investments or you don’t feel comfortable going against a particular trend
Remember that most people enter the market at the end, during the phases of thrill and euphoria, at the point of maximum financial risk, buying when prices are expensive.
Then, when things start to change, they enter the fear mode and sell at any price the market is offering. This is the best moment to buy, especially if you did your homework and understood that price and value are two different things, but it requires going against what everybody is doing.
Most people sold their stocks between the second part of 2008 and 2009, nobody sold in 2007, nobody sold at the beginning of 2008, they got out of the market with a huge loss. This is really something to keep away from in order to avoid capital losses.
Furthermore, recognise that a trend doesn’t last forever, but when there is a bull market people get more and more excited, projecting in the future what has happened until now.