Mass Psychology and the Stock Market
By Ryan Barua
Stock markets are essentially based on how mass psychology works, it’s a constant battle between market optimists and market pessimists, and in between is the undecided trader who looks to be part of whichever side dominates the market in a certain phase. We always believe that all investors and traders in the market are rational and take decisions based on facts alone, but in reality, a large portion of the market is driven by, what we commonly call, herd-mentality. People invest in what others are investing in, simply because the market at that stage is following a certain trend. A trader may not always lose money following the crowd, but they will most certainly never make permanent gains in the long run.
The Bull and Bear Market
The stock market is categorised into the bull market and the bear market, and both these markets tend to have different reactions from traders. In a bull market, the common psychology is to buy more, as the prices of shares rise consistently, so that investors can sell at an even higher price. Whereas the opposite holds true in the case of a bear market, where people are looking to sell because prices are consistently falling. However, both the bull and bear phase are essentially themselves determined by mass psychology, where people’s overall sentiment decides the outcome of the market. In a bullish phase, people are not willing to sell securities, while their demand is on the rise, thus, driving the overall prices up. Whereas in a bearish phase people are looking to sell and very few people are looking to buy, thus, the overall prices come down. These market trends are an outcome of what the market as a whole thinks, and people tend to follow the herd in their investment decisions.
The Dotcom Bubble
One of the most famous examples of mass psychology driving the market and creating false investor enthusiasm was the Dotcom Bubble in the late 1990s. With the advent of the internet and the rise of internet-based startups, there was a general sense of euphoria regarding any and all startups related to the internet. No investor wanted to miss out on the rise of internet-based companies, and were ready to throw large chunks of money towards such startups. They did this without looking at the fundamentals of the company, and thus threw caution to the wind. Most companies had no proper business model in place to generate revenues, profits and in many cases also had unfinished products. Investments in these companies were completely speculative, and valuations were based on the future potential earnings of the company. This led to a situation where there was excessive capital in the market, and most of the IPOs were inflated to many times their actual value. The entire situation occurred because of the hype created around internet-based startups and people were all too willing to join the herd since no one wanted to miss out on the action. Even those investors, who were rational and usually based their investment decisions on technical analysis, were forced to reassess their choices because there was a bull market. Ultimately the bubble burst and companies collapsed en-masse causing the market to crash. A lot of investors ended up losing a lot of their money because they submitted to the prevailing market sentiment and followed the herd, instead of looking at the fundamentals and doing a proper technical analysis of the companies.
The 2008 Financial Crisis
The financial crisis of 2008, is perhaps one of the worst financial crises in recent history, where dozens of banks failed and millions lost their jobs in the US, and its ripple effects were felt all across the globe. The financial crisis occurred due to a variety of factors, from low interest rates to lax mortgage lending policies. The housing market for a long time was seen by investors as a safe space, where easy money could be made, especially after the dotcom bubble. Mortgage-backed securities, which were full of subprime loans, lost most of their value with a huge increase in delinquency rates. Many investors chose to invest in these securities without looking at the ratings and the data, as they were confident that the housing market was stable because everyone was investing in these securities and many big institutions also had lots of investments in them. Eventually, investors lost most of their money and were barely able to recover anything. This crisis again highlighted the strong impact of herd-mentality pushing market trends, which eventually turned out to be unsustainable.
Role of Behavioural Finance
Behavioural finance is a subfield of behavioral economics, which explains that a large portion of the decisions taken in the stock market are based on psychology and biases. Behavioural finance tells us that people always tend to follow what the masses are doing because of the fear of being alone or the fear of missing out. People often feel more secure being part of the crowd than being away from one, and a lot of their decisions are based on societal influences. Investors in the stock market often panic sell, or go on a buying spree based on what everyone else is doing. Moreover, people often have inherent biases, and these biases often drive their investment decisions, especially when their biases are reaffirmed by what others are also doing. Mass psychology thus plays a huge role in investment decisions.
It’s human nature to do what the masses are doing and follow the crowd. However, when it comes to money, it’s prudent to do a proper analysis and look at the fundamentals before making any investment decision. It is always wise to look at all perspectives to arrive at a final outcome. There’s nothing wrong with following the crowd, as long as people do a thorough analysis, and make their ultimate decisions after due diligence.