The Psychology of Market Players

"While physics and mathematics may tell us how the universe began, they are not much use in predicting human behavior because there are far too many equations to solve." --Stephen Hawking

In our daily efforts to navigate the market, it is very easy to lose sight of what we are really trying to accomplish. The goal is to make money, and we do that by finding and buying the best stocks. But what really determines which stocks will be winners?

We spend an endless amount of time reading news, evaluating fundamentals, studying charts and thinking about the economy. All those things can be helpful in stock selection but what all investors and traders need to do to be successful is to predict human behavior. If you can predict the emotions of market players, you will be rich. Ultimately, both fundamental and technical analysis are just forms of psychology. At the end of the day, all that matters is whether the research you've done helps you to predict how people will act.

For example, when someone tries to calculate the value of a stock based on balance sheets and income statements, the underlying thesis is that if the price is a bargain, it will eventually attract buyers who are driven by finding a good deal. Too often, people forget that it doesn't matter how insightful your analysis will be if other people don't appreciate it as well. If you don't have other buyers seeing that a stock is a good value, then it is useless to do the research. Many fundamental investors are confident that the market will eventually figure out what they see, but if your timing is off it can be the equivalent of being wrong.

Many folks who rely on fundamental analysis assume automatically that others will act to take advantage of a bargain. That doesn't always happen, which is great if you are an activist investor or looking for acquisitions. The average investor, however, can't forget that good fundamentals without human behavior won't do you much good. 

The psychological aspects of a chart-reading approach are quite a bit more obvious. Charts are really nothing more than a graphical depiction of human emotions. Chartists believe that they can extrapolate how people will act in the future based on how they acted in the past. The theory is that as losses or profits grow it creates certain emotional responses that cause a stock to move in certain ways. Obviously, this is highly complex and many things, such as time periods and external news, will have an impact.

One thing that is quite easy to overlook in trying to predict stock movement is that human behavior is often a result of perceptions about how other humans will act. If enough people think that the 50-day simple moving average is important, then it will be important, even if it is just a random number.

The point is that it is extremely important to think about the market in very human terms. We constantly have to gauge what will drive people to act. Right now, the primary emotion driving the market is fear of underperformance. If you can appreciate that and embrace it, then navigating the market will be much easier.

An important thing to keep in mind is that human behavior often isn't rational. What seems reasonable often doesn't apply to the market because that is the way humans behave. It is important to appreciate that being irrational is a very common state for the market, and you can't fight crazy.