Sentiment Indicators: Stock Market Psychology and Behavioral Finance: What Investors Need to Know

Financial success is not rocket science. This is a soft skill, and how you do things is more important than what you know. Everyone can see the same stock prices, see the same charts, and have access to the same balance sheets and management commentary, but not everyone will get the same results in their trading and investing process. This ultimately comes down to the single most important factor responsible for all outcomes: our psychology and the subsequent behavior caused by this. Most of the time, this happens because of pre-existing beliefs and blind spots that most of us are unaware of. That they exist. Below are some psychological/sentiment indicators that can help you decipher various aspects of the market.

VIX: This index generates a prediction of volatility and can indicate the speed and range of price changes over a period of time. Investors may use her VIX to measure market sentiment, specifically how fearful market participants are.

Put-Call Ratio: This ratio analyzes the volume of puts (right to sell an asset) and calls (right to buy an asset) over a period of time. Investors use this ratio to gauge the overall sentiment of the market, as it can indicate a possible reversal in a market trend.

Fear and Greed Index: Fear and Greed Index is a market sentiment indicator that measures investor sentiment and psychology in the stock market. This provides a market overview of whether market participants are primarily driven by fear or greed at a particular point in time.

Markets may become voting machines in the short term, but they also provide a prism that allows us to believe what ‘groups’ are thinking, leading to the ‘illusion of indestructibility’, ‘collective rationalization’. ” or simply “collective rationalization”. “Don’t notice the pitfalls.”

According to behavioral finance theory, there are several types of cognitive biases that can influence investor decisions. After all, if you are aware of the most common ones, you can avoid them to make more rational decisions. It’s not what you do in the market that matters, but what you don’t do.

overconfidence

Most people tend to overestimate their abilities in various areas. Overestimating how much you know about the market or a particular stock can lead to dangerous situations, such as trying to time the market to predict the best time to buy or sell stocks, or overinvesting in expensive stocks. You will be tempted to make bad decisions. Risk stocks that have a high possibility of incurring losses.

herd psychology

Humans are social animals, so it is our natural instinct to conform to the crowd. From the hottest new fashion trends that everyone is wearing to crowded restaurants that require reservations months in advance, people tend to make choices based on what others are doing. However, in financial markets, herd mentality can lead to asset bubbles (when the price of an asset such as stocks rises rapidly but ultimately falls) or a market crash that occurs when many investors sell their stocks. may cause.

loss aversion

Even if you win more than you lose, people feel the pain of losing more strongly than the elation of victory. From an economic perspective, investors often hold on to stocks that should be sold to avoid realizing losses. Conversely, if waiting for a market rebound is a better option, you may sell prematurely to avoid further losses. Investors with a strong loss aversion bias often have portfolios that are too conservative and below market standards.

confirmation

Confirmation bias explains how two people with opposing viewpoints hear the same information and each comes away believing that it confirms their opinion. When we have strong beliefs, we place more weight on evidence that supports those beliefs and minimize evidence that contradicts them. In the financial industry, confirmation bias can cause investors to overlook investment strategies and assets that are outside the bubble, causing them to miss out on important growth opportunities. You may also end up investing too much in one area because you haven’t analyzed the risks enough.

behavioral investing

Bias is an important element in behavioral finance, but there are other important elements in theory.

rule of thumb

Heuristics are processes that simplify problems when there is not enough information to make a “perfect” decision. In these cases, you may use shortcuts or rules of thumb to make decisions that you think are correct. Heuristics simplify the decision-making process. This also simplifies the financial decision-making process. Without these, you will need to spend more time making decisions. However, relying on heuristics without carefully analyzing investment options can lead to irrational or incorrect decisions.

mental accounting

Mental accounting places different values ​​on money based on how you obtained it. For example, if you buy a winning lottery ticket, even if you have carefully budgeted your salary, you may end up spending all of your money on an unexpected purchase. This can lead to irrational financial decisions.

anchoring

Anchoring is a type of heuristic that unconsciously uses irrelevant information as a reference point. Past values ​​are common anchors. For example, let’s say you bought a stock for 1 million yen. If even $100 starts to lose value, you may want to hold on to it because you don’t want to sell it for less. Salespeople take advantage of anchoring by starting negotiations at a price well above market price. The high price acts as an anchor, so when the price falls it will look like a bargain.

Successful trading and investing requires more than just having the right processes and discipline. In the long run, the most economically difficult skill is to stop the goalposts from moving.