Why Market Psychology Matters

Most studies have shown that a majority of stock market traders, especially beginners, end up losing quite a bit of money. Many first-time traders will lose money on their first few trades and give up, never to invest in the stock market again.

More often than not, when money is lost, emotions are more at fault then the system or chart being used. Every investor has them, and they are a powerful part of trading on the stock market. Not only do your emotions affect your own personal ability to make money online, but the mass emotions of all the traders on the stock market actually have major influences on the price of stocks.

If you can learn to control your emotions and think logically when approaching every buy and sell order, you will be able to pick winners more than half the time. That is all it takes to make money investing in stocks.

Common Emotions

Fear

Fear is the most common emotion stock traders will feel. This is especially true in the beginning, when losing money is a foreign feeling and there are often friends and family that are skeptically waiting to see the results.

Here is an example to show why fear can be such a strong motivator and cause extreme financial losses.

Imagine one morning you wake up and pull open your laptop to check your stock portfolio. As you start to login to your broker, you see a news flash on the screen about something happening in China that was causing a market panic in America. You get a pit in your stomach and finishing logging in. Your worst fears are confirmed when you look at your portfolio and see that you have already lost 30% of your investment. You had been working at it for a year and were up 15% for the year. Now, in an instant, you are down 15%.

To make matters worse you can still see the stocks plummeting. Your portfolio value is plummeting off a cliff and you are literally watching money disappear on the screen. Every minute you wait is another $100 lost.

Most investors, especially beginners, will throw in a market sell order for their entire portfolio immediately. See our stock order types page if you don’t know what this means. A market sell order will sell immediately to the highest bidder. This means you will probably not even get the current value for your shares, you will get whatever is being bid at that minute. Unfortunately, most people are selling,  not buying, so another couple hundred dollars is lost when the shares sell for less then current value.

This kind of day happens a couple times a year in the stock market. Oftentimes within a week, the market has rebounded and most shares of stock are worth the same amount, or even more, than they were before the doomsday.

emotions on stock market psychology
The chart above shows the 2015-2016 stock market. The two large dips occurred when China deregulated their currency, and Britain  voted to exit the European Union. Note that both times the news was followed by intense drops in stock prices. Also note that the market recovered in less than 30 days both times.

In the chart above you can see the effects of fear on the stock market during Black Monday 2015 and Brexit. While the news announced on both of those days was not great news for the U.S. economy, the stock market made it seem like the world was crumbling. This is how fear drives the market. Once bad news is released a large number of people sell. Because so many investors are selling, and not nearly as many are buying, the price is driven down to meet supply and demand (see our lesson on what makes stock prices move). As the price drops, more and more investors get nervous about their investments and sell in order to maintain what gains they have made. This is stock market psychology 101.

After the fact it always may seem obvious that the market would quickly recover, but in the heat of the moment, as money pours out of your portfolio, emotions are high.

stock market IPO courses

Greed

The psychology of greed in trading plays just as big of a roll in losing money as fear. Greed stems from the fear of missing out on gains. There are a few ways it rears its ugly head.

The first way is when you start to make profits on a certain winning trade. You are up 20-30% and feeling good. Part of you wants to sell, lock in the gains, and head to an early dinner. But another part, a much greedier part, is terrified that if you sell, the price will continue to climb and you will miss out on gains.

A lot of beginning investors feel frustrated when they sell a stock too early and it goes up another 5-10% before balancing out. However, it is important to remember that very few investors actually purchase shares of stock at the very bottom of a downswing, and then sell them at the very top. Nearly all of the investors involved in trading purchased somewhere in between and sold somewhere in between. See the diagram below.

trading psychology - greed

Consider the example above. Investor A and Investor B both made money, even though they both sold early and bought after the stock price entered an uptrend. Investor C purchased at the lowest point, and had one point had made more in gains than either of the other investors. However, greed won out, and Investor C’s unwillingness to sell caused them to lose all of their gains. Don’t be Investor C.

The second way that greed rears its head with investors is the need to be invested in something. Oftentimes beginners have issues with their cash burning holes in their pockets. After selling shares of stock, they feel an immediate need to enter into another trade. While it is true that an investor is not making money when their portfolio is all cash, they are also not losing money. Sometimes there will not be a good opportunity in any of the stocks that you are tracking. That is fine – wait until an opportunity presents itself.

Overcoming Trading Emotion

Systems

Successful traders develop systems and rules. They build their trading around specific strategies and then they stick to those strategies no matter what. They understand trading psychology and that emotions have no place in investing. Here is an example.

One trader will never purchase shares of stock without stopping for ten minutes and finding reasons not to purchase the shares. Oftentimes beginning traders will get caught up in the momentum of a stock with a quickly climbing price and purchase at the highest point, only to be stuck holding shares of stock that are currently selling for significantly less then they paid for them.

Another strategy to eliminate emotion in trading is to purchase shares and immediately set stop losses. This forces the investor to sell their shares if the price dips below a certain number. The reason for this is that oftentimes the price of a stock will drop, but an investor will continue to believe that the price will turn around at any minute. They lose 5-10% a day for a week and suddenly realize they are down 25-30% on the stock and no signs point to a price recovery.

There are dozens of systems and rules that different traders use. Sticking to the system is more important than the system itself. As long as the system wins more than half the time, there is money to be made.

Using Trading Psychology to Increase Profits

Some investors utilize market emotions and trading psychology to their advantage. As seen on the graphs above, fear can drive stock prices far below where they should be in the short term. If the fear is overhyped, and it is pretty clear that the company or index will rebound, it is said to be oversold.

Investors that can recognize when a stock is oversold and is nearing a bounce can make significant profits by purchasing shares right as the stock price begins climbing again and riding the price back up to where it was before the fear struck.

Other investors utilize greed by tracking stocks with a lot of momentum and rapid price increases. They know that greedy buyers will keep jumping into the stock, driving the price up, and eventually it will probably drop and so they short the stock when it looks ready for the drop.