Psychology and Market Cycles

The continuous market cycles that occur produce different psychological effects on those that participate.  For example, at the peak of the investment cycle traders and investors feel sanguine about the returns they’ve realized up to that point in the market cycle. This is usually followed by a sense of dread when they see those returns begin to gradually dwindle and eventually turn into losses.

Unfortunately, most traders and investors experience these fear and greed cycles time and again.  This is due to the simple fact that most traders and investors don’t have a plan to properly manage risk and reward. Furthermore, they don’t possess a clear understanding of probabilities as it relates to making trading decisions.  These deficits subject traders to making decisions based on their emotions of fear and greed.  In order to mitigate these emotions, traders need to have a strategy that can help them buy low and sell high. Easier said than done, as you might imagine. But without a strategy, trading and investing can be extremely challenging

In order to deal with some of these challenges, a trader/investor must understand the various stages of the collective psychology of traders and investors. These market cycles can occur over many years, but smaller episodes happen almost daily.

Psychology and Market Cycles

The emotion that accompanies the first phase of the market cycle is optimism. This happens when the market has been in a sustained uptrend for many months, perhaps years.  In this environment, the prospects for earnings and for the economy look rosy.   Traders are feeling comfortable buying, as they perceive little risk in putting money into the stock market.  As the market continues higher, optimism turns into excitement as the early buyers are starting to garner hefty profits and every pullback is seen as another buying opportunity.  This perception is there because buyers are being rewarded for purchasing every retracement.

As the market cycle continues to accelerates to the upside, the thrill phase begins as profits increase substantially and investor confidence is through the roof.  Then comes the euphoria phase which is when profits come so easy that most traders and investors feel that they must take on leverage and begin to ignore simple risk management principles.  Although on the surface it seems like nothing can go wrong, the reality is that this is the point of maximum risk in the cycle, but everyone is too blinded by greed to come to this realization.  This phase is where institutional investors have tons of liquidity to unload millions of shares of stock as there are huge numbers of willing buyers. This is the distribution phase.

As the new pool of buyers begins to diminish, the market starts to rollover.  Initially it looks like another garden-variety pullback; that is, until the market fails to take out the prior high watermark and the prior lows are breached.  This kicks off the anxiety phase of the cycle as some of those easy profits begin to not be so easy anymore. In addition, some of the earlier gains begin to slowly evaporate.

The denial phase begins as investors start to rationalize their decisions for holding on to losing trades as good long-term opportunities. The logic is that those positions will eventually come back and make them whole. As the market continues to go lower and the losses continue to mount, denial turns into fear that causes paralysis and confuses traders and investors into doing nothing (like a deer in the headlights).

The persistent selling provokes a sense of desperation and dread among traders and investors as their resolve to hold on for the long term begins to crack.  At this point, it doesn’t take much for panic to set in as the terrible reality of what the losses mean is too much to bear. This is the most emotional phase of all the market cycles.

With the selling intensifying, investors reach their breaking point. This is referred to as the capitulation or give-up phase in which investors have to sell simply to relieve themselves of the excruciating pain they’re experiencing.  This is the point in the market cycle of maximum financial opportunity as the institutions are accumulating shares and buying futures contracts for the recovery that most likely is forthcoming.

Invariably, the market recovers soon after the masses have given up. As the recovery begins, investors become depressed as they realize that they have made a terrible mistake in selling near the lows.  This phase is where many question whether they should be traders, or in the markets at all.

Finally, as the market slowly recovers, investors slowly become hopeful again and begin dipping their toes into the water, so to speak. This happens only after a sustained rally is underway, of course, and the cycle begins again.

If we succumb to the emotional roller coaster of investing and trading as pictured in the illustration, we will eventually end up financially and emotionally bankrupt. Instead, learn to implement a low-risk, high probability strategy that allows you to time the market and navigate through this emotional market cycle, without the emotional turmoil. Or… well, you already know the alternative.

Until next time I hope everyone has a great week.

Learn to Trade Now

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