How The Power Of The Masses Drives The Market
The incessant intraday struggle stock market between the bulls and the bears is what drives market rallies and precipitates market declines. Regardless of the style of analysis or system employed by traders, one primary aim of their trading endeavors is to understand the degree of control held by the bulls or bears at any given time and to predict who should hold power in the near to distant future. Unfortunately, traders' natural desire to follow the crowds often gets in the way of seeing this clearly. Here we'll take a look at how psychology and behavioral finance propel bull and bear markets.
The Force of Emotion
One way to see the market is as a disorganized crowd of individuals whose sole common purpose is to ascertain the future mood of the market (the balance of power between bulls and bears) and thereby profit from a correct trading decision today. However, it's important to realize that the crowd is comprised of a variety of individuals, each one prone to competing and conflicting emotions. Optimism and pessimism, hope and fear - all these emotions can exist in one investor at different times or in multiple investors or groups at the same time. In any trading decision, the primary goal is to make sense of this crush of emotion, thereby evaluating the psychology of the market crowd.
Charles Mackay's famous book, "Extraordinary Popular Delusions and the Madness of Crowds", is perhaps the most often cited in discussions of market phenomena, from the tulipmania in 17th-century Holland to almost every bubble since. The story is a familiar one: an enduring bull market in some commodity, currency or equity leads the general public to believe the trend cannot end. Such optimistic thinking leads the public to overextend itself in acquiring the object of the mania, while lenders fall over each other to feed the fire. Eventually, fear arises in investors as they start to think that the market is not as strong as they initially assumed. Inevitably, the market collapses on itself as that fear turns to panic selling, creating a vicious spiral that brings the market to a point lower than it was before the mania started, and from which it will likely take years to recover.
The Nature of Crowds
The key to such widespread phenomena lies in the nature of the crowd: the way in which a collection of usually calm, rational individuals can be overwhelmed by such emotion when it appears their peers are behaving in a certain universal manner. Those who study human behavior have repeatedly found that the fear of missing an opportunity for profits is a more enduring motivator than the fear of losing one's life savings. At its fundamental level, this fear of being left out or failing when your friends, relatives and neighbors seem to be making a killing, drives the overwhelming power of the crowd.
Another motivating force behind crowd behavior is our tendency to look for leadership in the form of the balance of the crowd's opinion (as we think that the majority must be right) or in the form of a few key individuals who seem to be driving the crowd's behavior by virtue of their uncanny ability to predict the future. In times of uncertainty (and what is more uncertain than the multitude of choices facing us in the trading universe?), we look to strong leaders to guide our behavior and provide examples to follow. The seemingly omniscient market guru is but one example of the type of individual who purports to stand as all-knowing leader of the crowd, but whose façade is the first to crumble when the tides of mania eventually turn.
Choices, Choices, Choices …
Due to the overwhelming power of the crowd and the tendency for trends to continue for lengthy periods of time on the basis of this strength, the rational individual trader is faced with a conundrum: does he or she follow the strength of the rampaging hordes or strike out defiantly with the assumption that his or her individually well-analyzed decisions will prevail over the surrounding madness? The solution to this problem is actually quite simple: follow the crowd when its opinion jives with your analysis and cut your losses and get out of the market when the crowd turns against you! Both following the crowd and getting out present their own unique challenges.
The Risks of Following the Crowd
The key to enduring success in trading is to develop an individual, independent system that exhibits the positive qualities of studious, non-emotional, rational analysis and highly disciplined implementation. The choice will depend on the individual trader's unique predilection for charting and technical analysis. If market reality jives with the tenets of the trader's system, a successful and profitable career is born (at least for the moment).
So the ideal situation for any trader is that beautiful alignment that occurs when the market crowd and one's chosen system of analysis conspire to create profitability. This is when the public seems to confirm your system of analysis and is likely the very situation where your highest profits will be earned in the short term. Yet this is also the most potentially devastating situation in the medium to long term, because the individual trader can be lulled into a false sense of security as his or her analysis is confirmed. The trader is then subtly and irrevocably sucked into joining the crowd, straying from his or her individual system and giving increasing credence to the decisions of others.
Inevitably, there will be a time when the crowd's behavior will diverge from the direction suggested by the trader's analytical system and this is the precise time at which the trader must put on the brakes and exit their position. This is also the most difficult time to exit a winning position, as it is very easy to second guess the signal that one is receiving, and to hold out for just a little more profitability. As is always the case, straying from one's system may be fruitful for a time, but in the long term, it is always the individual, disciplined, analytical approach that will win out over blind adherence to those around you.