Riding the Rollercoaster: How Emotions Drive the Stock Market

Our brain is one of the most sophisticated structures known to humankind. Initially, it was designed to help our ancestors survive from predators, weather conditions and what not, but nowadays its used to make all sorts of financial decisions, those related to savings and investments. Unfortunately, our brain was not always well trained to handle such tasks and often falls prey to certain cognitive biases.

As long as you are a living and breathing human, you are naturally wired to get emotional about your money, irrespective of whether you’re a new comer or a seasoned investor. Take Covid-19 for example, as the pandemic spread, stock markets around the globe faced volatility leading to many investors making impulsive decisions, such as selling their stocks out of fear of losing all their money. On the contrary, during the dot-com bubble of the late 1990’s, many investors got over-confident about the potential of the technological sector and were willing to take on significant risks to maximise their returns.

This kind of behaviour in the market is as old as investing itself. When the market is on a rise, the fear of missing out on potential returns drives investors to impulsively purchase large quantities of highly valued stocks. And when the market is plummeting, investors sell their stocks, following herd mentality, to curb further losses. This takes investors on a whole new rollercoaster of market emotions that they would experience, as shown below.

Cycle of Market Emotions

Herd behaviour can be difficult to predict and control, but there are strategies that investors use to protect themselves. One strategy is to focus on long-term investing, rather than short-term market movements. By investing in a diversified portfolio of stocks that have a proven track record of success, investors can reduce their exposure to the fluctuations of any one company or industry.

Another strategy is to conduct thorough research and analysis before making any investment decisions. By understanding the fundamentals of a company and its industry, investors can make a well informed decisions based on objective information, rather than on the actions of the herd.

Although it is natural for you to feel emotions like greed, fear and hope when investing in the stock market, one should be aware that giving in to these powerful emotions can profoundly harm not just the investor but also the market and the economy on a larger scale.

In my opinion, this is the difference between a new comer and a seasoned investor. Experienced market investors are well aware of their strengths, weaknesses, and how people react to different situations. While a new comer would extrapolate a short term trend assuming it would last for a much longer time. Maybe indefinitely.

However, having the awareness that these emotions stand right at your doorstep and recognising them, can help you make rational decisions and bring significant improvements in your investments.

The 3 Most Powerful Emotions In The Stock Market:

Fear

Fear is a survival instinct. But sometimes this emotion can work against us. When faced with adversity, humans are naturally trained to choose “flight” over “fight”; similar is the case with the stock market. Who likes to see red stains on their portfolio as they continue to lose money not knowing when it will stop? Whether it's the fear of missing out on profits or even worse, suffering large losses over a sustained period of time, investors tend to lose themselves in the herd by buying or selling their stocks impulsively.

Greed

The line between greed and ambition is incredibly thin. Thus, it is imperative to know when you have enough. Drawing this line is something that many people, including the wealthiest among us, seem to struggle with. This emotion acts as a blindfold making investors oblivious to proper money management and instigates them to take more and more risks throwing them down a spiral.

Hope

Hope is a double-edged sword. With the right intensity, it helps investors look past the uncertainty and develop a positive outlook on future gains. But on the other side, it can be a lethal emotion that also clouds the same investors from fatal down-pits in the stock markets.

The Bottom Line

While we all are aware of keeping our impulses aside when implementing strategies required for a successful long-term investment, in reality it is very hard to practice what is preached. So the obvious question at hand is: how does an investor control their emotions while simultaneously making rational decisions?

There are multiple factors that come into play, but the most determinant one is simply experience. Theories and clever experiments of various authors can only teach you so much, but to truly learn to fight the bulls and the bears, you have to get your hands in the mud.