Financial Markets go through different cycles that produce different psychological effects on those that choose to participate. At market peaks of an investment cycle, traders and investors feel satisfied about the returns they’ve realized and believe that the favorable market environment will remain in place for an extended period of time. In other words, they become complacent and tend to dismiss any red flags that begin to emerge. This good feeling is usually followed by a sense of nervousness when the markets slowly start turning lower.
Unfortunately, this occurrence is the result of those traders and investors not having a plan in place to properly manage risk, thus they are subject to their emotions. Moreover, they also don’t have a strategy that helps them time the markets, meaning they don’t know when to get in (buy low) and get out (sell high). As you might imagine, this poses a big challenge for inexperienced traders and investors.
In order to deal with some of these challenges a trader/investor must understand the various stages of trading psychology.
Stages of Trading Psychology
Emotional Stages of an Up Trend in the Market
Traders experience optimism when the market has been in a sustained uptrend for several months and the prospects for earnings and the economy are in the recovery phase. In this stage of the market traders feel comfortable buying as they see little reason to not put some money into the market because they perceive risk to be low. As the market continues higher, optimism turns into excitement as early buyers are starting to garner nice profits and every pullback is seen as another buying opportunity. In this phase, buyers are rewarded for purchasing every pullback, and like Pavlov’s dog, will continue until they are no longer rewarded for their actions.
Enthusiasm & Exuberance
As the market accelerates to the upside the thrill phase begins. Enthusiasm sets in as profits increase substantially, transitioning to exuberance as investor confidence goes through the roof.
Then comes the last and final uptrend stage, Euphoria, which is when profits come so easy that most traders and investors feel that they must take on leverage and begin to ignore simple risk management principles. Although on the surface it seems like nothing can go wrong, the reality is that this is the point of maximum risk in the cycle. This easy money phase of the market makes many blind with greed. This period is where institutional investors take advantage of that greed as there are plenty of willing buyers which produces tons of liquidity allowing them to unload (sell) a lot of stocks.
Emotional Stages of a Down Trend in the Market
As the new pool of buyers begins to diminish the market starts to rollover. Initially it looks like another garden-variety pullback, that is, until the market fails to take out the prior high watermark and the prior lows are breached. This kicks off the anxiety phase of the cycle as some of those easy profits begin to not be so easy anymore. In addition, some of the earlier gains begin to slowly evaporate.
Denial & Fear
The denial phase begins as investors start to rationalize their decisions for holding on to losing trades. They feel that they are invested in good companies and profits will come back if they hold on long enough. As the market continues lower and the losses continue to mount, denial turns into fear that causes paralysis and confuses traders and investors into doing nothing (like a deer in the headlights).
Despair & Panic
The persistent selling produces a sense of desperation among traders and investors as their resolve to hold on for the long term starts to crack. It doesn’t take that much time for panic to set in, as the terrible reality of what the losses mean for every trader becomes too much to bear. This is the most emotional phase as the pain becomes overwhelming.
With this intensified selling, traders and investors reach their breaking point. This is referred to as the capitulation or give-up phase in which traders and investors have to sell simply to relieve the excruciating pain they’re in. This is the point of maximum financial opportunity as the institutions are again having a field day because sellers are rampant as the they begin accumulating shares and buying futures as a recovery is likely forthcoming.
Discouragement & Dismay
Invariably, the market does recover after the majority have given up and that causes investors to become despondent and depressed as they realize that they have made a terrible mistake in selling near the lows. This phase is where many question whether they should be traders or in the markets altogether.
Finally, as the market slowly recovers, investors slowly become hopeful again and begin dipping their toes into the water. This happens only after a sustained rally is underway, of course, and the cycle begins again.
As of October 25, 2019, the S&P 500 is crossing all-time highs. Some would think that presently the market is in the euphoria phase but in actuality, a primary reason we’re moving higher is the fact that many market participants are actually under-invested. This is due to concerns over the China trade talks, Europe slowing and all of the negative factors affecting the economy. This puts us nowhere close to being in a euphoric state. However, sentiment can shift quickly and with the rising market, investors may start to feel like they’re missing out. This could lead to them putting money into the market.
If we succumb to the emotional roller coaster of investing and trading as pictured in the illustration, we’ll likely never reach our financial goals. Instead, implementing a low-risk, high probability strategy that helps us time the market and navigate through this emotional cycle is the best course of action. What do you think?
Until next time I hope everyone has a great week.