We review certain aspects of individual and market behavior that are commonly observed in the stock markets. This will help you understand how and why people act in the manner that they do when they enter into stock market transactions. This knowledge will help you to understand not only your own behavior but also give you a deeper insight into the causes and motivations behind the behavior of your fellow investors. An understanding of how people behave in the stock markets will enable you to make more money through better and wiser investment decisions.
Human beings are basically irrational
Most human beings act irrationally most of time. They are motivated by all kinds of emotions, impulses of the moment, instincts, prejudices, wishful thinking, hopes, fears, desires-almost everything, except logic and reason. These motives influence the buying and selling decisions of investors and other stock market operators in the same way that they influence their decisions in other spheres of human activity. Therefore, you should not try to understand stock market behavior solely on the basis of intelligence, reason and logic. If you do so, you are likely to make serious errors in your investment calculations and decisions.
If human beings were to always behave rationally and logically then both stock prices and their future movements would be totally predictable. Shares prices, in such a situation, would generally hover closely around their intrinsic values and opportunities for making money by buying under-priced shares and selling them when they become over-priced would virtually disappear.
We are all part of a crowd
A crowd is a collection of people gathered in one place. Stock market investors and speculators may not be present in one place physically but mentally they are all linked together in the same way as is an actual crowd. They read the same newspapers, they deal with the same group of stockholders, they watch the same share price movements, and they tend to react to news and events in the same manner. For all practical purposes, therefore, the market is a crowd, and stock market behavior can best be understood and interpreted if viewed as crowd behavior.
Crowd behavior is very different from the behavior of individuals who make up the crowd. A crowd never reasons or thinks it is always swayed by emotions. Emotions being extremely contagious sweep through the crowd–sometimes propelling it in one direction, at other times in another. This is the reason why crowds are never moderate in their approach–given to extremes of behavior. They also over-react, pushing share prices up to unrealistically high levels or stamping them down to very low levels. Over-reaction is a universal phenomenon exhibited by stock markets all over the world. Shrewd and knowledgeable investors make money by taking advantage of the fact that share prices always over-react–they pick up grossly under-priced shares and sell them when they become grossly over-priced.
In order to do so, however, you should be able to insulate yourself from the contagion of the crowd. Don’t be drawn into the crowd–stay outside it. If you wish to be a successful investor you will have to learn to keep your head when everyone else seems to be losing theirs. Study crowd behavior, which the crowd in action, anticipate and predict its movements but don’t become a part of it. People behaving to the crowd never make money; they only provide an opportunity for others to do so.
Admit your mistakes
Most human beings find it very difficult to admit their mistakes. They usually rationalize and invent reasons for justifying their actions and assessments, put the blame on somebody else, ascribe their misfortunes to ill-luck or fate–in fact, do everything but admit that they have been wrong. Failure to admit one’s mistakes can be disastrous in the stock markets.
Unless you admit your mistakes, you will not know when and where to cut your losses. There is nothing unusual about making a mistake. Everybody makes mistakes, particularly when buying and selling shares. Even the most successful stock market operators readily admit that they make mistakes quite frequently. There is an oft-quoted stock market maxim; “Every time a share is bought or sold, somebody somewhere has made a mistake.” Therefore, don’t be ashamed to admit your mistakes. The quicker you are in admitting your mistakes, the easier you will find it to pull out of bad investments in time.
Greed and fear
Greed and fear are the two most dominant emotions found in the stock markets. They are the two extreme aspects of crowd behavior. Greed is the most prevalent emotions in a rising market; fear takes over in a falling one. Greed causes fanatic buying whereas fear causes panic selling. It is because of greed and fear that the markets always over-react in booms and depressions. If it were not for greed and fear, share prices would not fluctuate as violently and as erratically as they actually do.
Whenever you find that you have achieved or crossed your investment objectives, you should sell. Don’t be greedy and hold on to your shares in the expectation of future gains. An overbought market is highly unstable and may collapse at any moment. On the other hand, don’t panic into selling after a steep fall in share prices. Remember, that recessions and slumps are temporary phenomena–sooner or later they are bound to give way to a rising market. If you hold on, you will find that the subsequent rise in prices is likely to compensate you amply for the waiting period.
Don’t be a snob
Snobbery is as prevalent in the stock markets as in other areas of life. There are many investors who buy shares not because of their intrinsic worth, but because of their snob value. Even their investment selections are dictated by the snob value of various scrips. Avoid being a snob. Snobbery doesn’t pay in the stock market. Foreign sounding names are not necessarily gateways to wealth and riches. You will do well to base your investment decision on things more solid and realistic than mere snobbery!
Seeing the reality for what it is
Many of us view the stock market with preconceived notions and ideas. We think that the market actually is what we think it ought to be. Most of us make the mistake of substituting reality with wishful thinking. The market is not concerned with what you think it ought to be. It is what it is. If you wish to be successful, you will have to learn to view it as it, not as what you would have it to be.
Don’t get influenced by your own concept of an ideal market while making your buying and selling decisions. Don’t let preconceptions and wishful thinking influence you–be objective and realistic in your approach to investment matters.
Keeping up with your neighbors
Many people buy shares in a particular company simply because all their friends and colleagues seem to have shares in it. They do so because they do’t want to be left out. Don’t buy shares in a company simply to keep up with the Joneses. There is no reason to presume that your neighbors and colleagues have better investment knowledge and judgment than you. In fact, keeping up with the Joneses is one of the ways in which you get sucked into the crowd. As we have seen earlier, being part of a crowd is not likely to get you anywhere. You must always retain your objectivity and independence of judgment while taking investment decisions.
Learn to take risks
When you decide to buy shares you are knowingly and willingly exposing yourself to a variety of risks. The shares you buy may not appreciate in value or, worse, their price may actually plummet, leaving you with a capital loss. The company whose shares you buy may not perform as well as you expect, or even if its performance were to live up to your most optimistic expectations the market may not be sufficiently enthused over it to push its share price. Moral: don’t buy shares unless you are emotionally and temperamentally prepared to take some risks.
Once you decide to enter the stock market, then don’t let the possibility of making losses prevent you from taking reasonable and calculated risks. The higher the risk, the greater the potential rewards. Low risks invariably imply low returns. Therefore, don’t play safe. Learn to take risks. If you don’t risk your capital, you will be depriving yourself of the only realistic chance you will ever have of becoming rich. Remember, the economic structure of the world is rigged in favor of the bold risk-taker.
How do you know that you are taking sufficient risk? The first sign after you have made a risky investment will be a feeling of unease and anxiety. If any investment gives you a feeling of smug satisfaction, then it means that you have not taken the required degree of risk necessary to earn big profits. The best investments are those that make you toss and turn in your bed at night and not those that give you sound, carefree sleep Remember, as an investor your main goal is making money and not sound sleep. As the Swiss say, a “state of worry” is the price you pay for the opportunity of making money!!