The Market Has Its Temper

In the 1710s, as the price of the South Sea stock rose, the famous scientist Isaac Newton made significant profits.

However, after the stock soared, he rebought it almost at its peak, resulting in large losses.

It seems that Newton could calculate the motions of heavenly bodies, but not the madness of people.

Many investors, not only Newton, may ignore the market's madness caused by market psychology, which matters in investing.

Simply put, market psychology considers market participants' overall sentiment and behavior.

Market psychology is shown by two opposing forces of investors in the market: bullish and bearish.

Market psychology becomes one sentiment when another is suppressed or even ignored.

It is a powerful force that can override the fundamentals and cause stock prices to move unexpectedly.

Greed and fear are the two primary motives behind it.

The market can be overwhelmed with greed and succumb to fear as well.

We can see the market mood as a pendulum, swinging back and forth between the two highest points: greed and fear.

Greed can lead to optimism and overvaluation, increasing the price above the “normal market value” and forming a price bubble.

Fear can bring pessimism, undervaluation, or even mental breakdown.

As market sentiment swings, boom-bust cycles often develop.

One of the most famous cycles was “tulip mania” which occurred in the Dutch Republic during the 17th century.

Because of their bright colors and exquisite shapes, demand for the recently introduced tulips increased significantly, pushing their prices up.

Rising prices attracted more and more investors.

From 1633 to 1637, even many middle-class and low-income families speculated in the market.

This contributed to enhanced optimism among investors, which pushed prices up further..

Investors believed the trend couldn't end. Greed had overtaken traders who were unwilling to take profit no matter how much prices rose.

Homes, estates, and industries were mortgaged, and lenders fed the fire.

Tulip prices had reached extraordinarily high levels.

The most expensive tulip bulb was the Viseroij, which sold for 3,000 guilders each.

At that time, 3,000 guilders could buy the following things:

2 lasts of wheat, 4 lasts of rye, 4 fat oxen, 8 fat pigs, 12 fat sheep, 2 hogsheads of wine, 4 tuns of beer, 2 tuns of butter, 1000 pounds of cheese, a bed with a fine mattress, a suit of clothes, a silver beaker, and a 500-foot boat.

How crazy it all was!

However, bubbles always burst.

Some investors began to doubt whether the prices would continue to rise, so they sold their holdings.

Investors grew fearful, panic selling ensued, and eventually, the market collapsed.

Tulip Mania occurred not because of the intrinsic value of tulips but due to investors' speculative motives.

The case is a powerful illustration of the influence of market psychology.

Herd behavior, where a large group of people acts that same way at the same time, is its by-product.

This one-way behavior leads to a collective "risk-on" mentality bringing asset bubbles or a "risk-off" mentality resulting in market crashes.

It affects not only the market cycle but also the business life cycle and even the economic cycle.

Market psychology can affect individual investors.

Being able to understand the current market psychology can aide traders in predicting its trend and is the basis for stock selection and timing.

The following indicators of market psychology can be useful in helping investors to choose entries and exits to their trades: the number of IPOs, the VIX index, stock indexes, P/E, the trading volume, OBV, MACD, KDJ, PSY, etc.

Adopting a contrarian investing strategy based on solid fundamentals can be fruitful when current conditions reach extremes due to market psychology.

"Be fearful when others are greedy. Be greedy when others are fearful," Warren Buffett said when referring to these types of market extremes.

But sometimes, it is hard to control our emotions.

Passive investing and AI advisors may offer some options.

What do you think about market psychology? Please share your thoughts in the comments.