Investing is never truly as simple as it seems – the dynamic is always changing, emotions can get involved, and psychological factors can affect crowd and individual behavior. These psychological and emotional factors have a heavy hand in decision making and can in fact affect the success or failure of investments.
The markets tend to work in cycles, between bear and bull, depression and growth, boom and bust, whatever you want to call it. But alongside the cycles of the markets come the cycles of emotions. Now, not everyone will face the same emotions individually, as individual behavior differs from the crowd (due to the nature of crowds exerting influence and control over the mass of individuals), but in general crowd emotion does start to converge in some sort of pattern.
This chart reflects one explanation of crowd emotion – optimism starts to boil into thrill and further into euphoria on the way up, while denial, fear, disbelief and panic set in on the way down. As markets/stocks rise at first, it starts to attract a bit of attention – the crowd is starting to pick up some senses of potential profitability; that’s the bait on the line.
The crowd might bite the hook on the dip – you always hear the “buy the dip” adage – and ride the emotional and profitable roller coaster on the way up. Some will take profits, some won’t. For those that don’t, the roller coaster back drown brings all the negative emotions out – you first think that it’s just another dip, then it keeps falling, and still you deny it. As it falls more, panic and desperation set in. The cycle below represents more of that emotional curve.
Humans are innately emotionally driven. The curve of emotions does a good job representing the range of emotions that are typically involved in investing, whether positive or negative. But we all can make our own decisions independently, and therefore don’t all feel these same emotions at the same times, or at all in some cases. It falls in line with Citi’s (C) panic and euphoria index – where the crowd might be towards one extreme or the other, individuals who differ will simply be drowned out by the noise.
To touch upon the crowd theme, here’s an excerpt from a previous article:
“Investing isn’t so much a solo game like blackjack. Investing comes with the crowd. One individual’s panic is hardly enough to make a dent in a group of one thousand, but when one hundred start to panic, more start to take notice. Crowds tend to exert more influence over individual decision-making than due to the influence and hypnotic nature of the mass involved. It’s like Le Bon’s idea of contagion as one of the three stages of a crowd – everyone in the crowd starts to follow ideas and emotions without question.
Euphoria can be derived from this subset of crowd psychology. As the crowd begins to win and win big, everyone else in the crowd might start to assume that they can too, by simply following the actions of the crowd.
And back to Le Bon – once a crowd starts to reason, it becomes the ultimate destructive force. Individual euphoria and panic (as well as other emotions) are hidden by the crowd if they differ from the crowd, but once the crowd feels the overarching euphoria (as we see now), the untouchability and defiance of what seems justifiable disappears; once the crowd begins to realize as a whole what it has just created from its euphoria, and begins to panic, the downward spiral eviscerates the crowd.”
So how does the crowd in turn correlate with individual psychological aspects? In a way, it can come down to heuristics. And in this case, it’s the heuristics pioneered by Danny Kahneman and Amos Tversky that have the most meaning – with investing, on predictions and uncertainty.
In a way, “people predict very little and explain everything; people live under uncertainty whether they like it or not; people believe they can tell the future if they work hard enough; people accept any explanation as long as it fits the facts…people often work hard to obtain information they already have and avoid new knowledge [because] man is a deterministic device thrown into a probabilistic universe” (Source – The Undoing Project by Michael Lewis). Amos sees that humans are intricately combining their judgments with their predictions and their predictions with reality in order to find something that makes “sense.” The heuristics that the two studied can help to explain why these disconnects and these observations occurred.
For one, there’s hindsight bias – most people are aware of hindsight bias, but it actually has a large effect on our decision-making processes. A study conducted by one of Amos’ students found that the subjects “all believed that they had assigned higher probabilities to what happened than they actually had…once they knew the outcome, they thought it had been far more predictable than they had found it to be before.”
So when we try to predict how a future investment will go – say, you might think Microsoft (MSFT) will go up 30% in one year, and give it a 60% chance of doing so, but after one year, if Microsoft had gone up 35%, you might have thought that you had given it an 85% chance. It’s not so much the fact that our hindsight (our original predictions/judgments) was wrong, but more so the fact the outcome is warping what we had originally believed.
If a stock like Tesla (TSLA) goes up almost 1,000% in one year, people believing in it might have said that they had known all along that this was going to happen – it did, but did you really think it would be 1,000%? Or was it 100%? This goes with point 4 of the first market cycle chart – it’s going to the moon, I knew all along. But that’s because hindsight bias might be making you think that you had correctly judged the outcome when in fact you hadn’t.
And when you change the information available to base judgments, that’s when you can change the decisions, or the probabilities assigned to choices. Amos and Danny coined this the “availability” heuristic – “the more easily people can call some scenario to mind – the more available it is to them – the more probable they find it to be.” Incidents that are more common, or vivid, or recent tend to be weighted higher by individuals and therefore deemed to be more likely.
Because judgments of events were seen to be quite volatile, reliability of judgments under the availability heuristic was something that the two doubted. While studying the heuristic, the questions had objectively correct answers. But in investing, that’s not the case. Economic recessions aren’t necessarily predictable – let’s go back one year and see if anyone had predicted that the market would have fallen so fast in March. Each event that happens in investing is unique, and therefore can’t be judged by simple instances.
It goes over to what has currently been happening in the markets – fresh off the March crash, the tech selloff started bringing back fears and cries of another crash – time will tell if that’s true – but why is everyone so quick to say crash? Memorability.
The March decline was rapid, unprecedentedly fast, and wiped enormous sums off portfolios – yes, a few of the tech selloff days and drops in the NASDAQ were reminiscent of that, but because it is such a memorable and recent event. Smaller drops go forgotten here. And when something so seemingly out-of-the-blue happens, why is that we were not able to think that it was likely? Because maybe we could not remember a time that it had.
So back to the market cycles – why do people get caught at the top? They see that the stock or the market has been rising steadily, and using that available information, might decide that the market/stock will keep rising, and that they will be right and earn a profit. They get caught looking at the recent past performance and extrapolate that into an overconfident view of the future return potential of the market/stock.
And if the cycle downwards begins, people start to think that the signs were always there, and believe that they should never have gotten caught at that point and made a mistake. But there’s a difference between what’s a mistake and what’s misfortune. Mistakes can be seen as making the wrong decision when the information is available to make the right one; misfortune can be seen as the wrong outcome from a decision made without all the necessary information.
The information to judge whether or not the market will fall will never truly be there, no matter how much you analyze or study it. So it’s not so much a mistake buying into the top as it is a misfortune – you just got caught at a time where there weren’t many more buyers willing to pay more than you did. You can use dozens of technical indicators, stare at charts all day, look at cash flows, but does the market really have to trade based on that?
Does the current market reflect any sense of a normal, evenly-valued world? Not exactly – some companies have seen earnings get crushed, doors closed, yet shares are still up – is it a bubble? Maybe. Things don’t always have to make sense. Yet that’s what we do – we try to make sense of everything.
Whether you’re just beginning to invest or have been investing for decades, you’ll realize that investing has its fair share of emotions and psychology; it’s natural. Emotions might tie us to certain stocks or certain sectors, and this “attachment” might arise from feelings of confidence, security, or optimism – say you bought Apple (AAPL) in the 1990s or early 2000s and sold it in 2015, you’d have a great return, but you might be drawn back to Apple because of the positive history you’ve had trading it. And on the other hand, there’s cases like BlackBerry (BB) which generated substantial returns during the dot-com bubble only to hover far below and never reach those highs again.
So don’t let emotions control your trading, or you might miss a great opportunity, or get stuck in a bad one. I’ve missed many great opportunities myself because of that – I couldn’t get myself to buy in at a certain price because it felt too high or not worth the risk, and missed out on great returns. It’s a learning process, where you never truly stop learning.
Psychological factors correlate with emotions; we might feel optimistic or euphoric about certain opportunities because we’re reminded of similar opportunities in the past, that those memories are more available. We might be quick to panic because we assume and see that the rest of the crowd is doing the same. Individual investors can play the game themselves, but the influence of the crowd will still be exerted. Crowd emotions can exaggerate situations where rational decisions wouldn’t have done the same – how else would a bubble form?
Investing is never something so simple as right or wrong, win or lose. It dives into the innate depths of emotions and psychological factors that affect whether we’re right or wrong, or win or lose. You can do everything in your power to analyze a company to ensure it is a good investment, only for a freak occurrence like the March selloff to completely change the outcome you had predicted.
And predictions and judgments are nothing more than hope – you make these predictions based on emotions, experiences, etc., and try to justify the outcome to fall in line with your prediction. But predictions can misguide us – everyone sees things differently, and what someone sees as a positive, someone else could see as negative; people can react differently to the same statements.
Investing combines all of that, especially here – authors all view different companies in different ways and have different expectations of future performance. Even if it doesn’t seem like it, there’s value in differing opinions, even if they’re wrong; maybe more of the crowd sees it in that light too, and you might be able to better understand the crowd now, and make your decisions based off that. It’s an individual game at heart, but one more so controlled by emotions and psychology than numbers.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.