Psychology and Behavior in Financial Markets

This article is part of a feature on the psychology of financial markets, written by Marion Lagrée for the blog.

The concept of cycles in financial markets

We have previously seen that financial markets fluctuate based on three major factors. Nevertheless, they still follow a certain trajectory, meaning they are considered cyclical.

William André Nadeau, a Canadian portfolio manager, identifies 8 phases in an economic cycle:

1. The severe recession (Q4 2008 and the first two quarters of 2009).

Driven by both rational and emotional factors, stock market crashes have left investors in a state of panic, bracing for the worst. GNI is declining.

2. Economic stabilization (April-May 2009).

The economic slowdown is decelerating. Stock markets that had experienced the sharpest declines due to emotional volatility during the previous phase are now rebounding.

3. The recession trough (June-August 2009).

The economy has stopped slowing down, with half of the sector in recovery and the rise in unemployment decelerating. The stock market has recovered from the emotional volatility of the previous downturn.

4. Economic Recovery 1 (Sept 2009).

With the recession over and the unemployment rate stabilizing, more than half of all economic sectors are showing positive growth. The stock market is advancing steadily, in line with rising corporate profits.

5. Economic Recovery 2.

With unemployment rates falling and corporate profits surging, the stock market is advancing faster than the improvement in fundamental data would suggest.

6. The beginning of economic growth.

Financial markets are pulling back after advancing too rapidly during phase 5, leading to a return to more normalized valuations. New investors are flowing in, driven by confidence despite the recent market disappointment. NBI is seeing rapid growth.

7. Advanced economic growth.

The economy is growing at a moderate pace. There is a trend toward overvaluation, particularly in sectors prone to speculative bubbles. This is the longest phase, where investors and consumers, as well as economists and analysts, are overly optimistic. It is at this stage that it becomes crucial to study finance behavioral.

8. The onset of recession.

Even as the economy enters a recession, its impact remains largely unseen. Stock market corrections are beginning, corporate profits are declining, yet consumers and investors remain largely unconcerned. They anticipate this downturn to be a short-lived period; however, at times, it can serve as a harbinger of much deeper financial and economic distress.

Individual Psychologies in Financial Markets

Behavioral misconduct includes:

• Cognitive: understanding, mental anchors, heuristics, and emotions (fears, desires, admiration, aversion, pride).
• Individuals or collectives.
• Self-Fulfilling Prophecies.

Regarding stock market behaviors, we can first mention the bandwagon effect. It reflects the herd mentality of retail investors, where once a majority begins speculating on a lucrative stock price, other shareholders follow suit. Within this wave of optimism, a speculative bubble forms and expands until an eventual burst occurs. This speculative euphoria can stem from an overvaluation of the sector in question.

Two types of mimicry are evident:informational, which involves mimicking the behavior of other investors who are assumed to be better informed, and the’self-referential which involves attempting to predict majority behavior in order to emulate it.

The’mental anchor consists in relying on one’s first impression or, in the difficulty of challenging it, even when memory in the sense of experiencemeans that past experiences will influence future decisions. Consequently, an individual may refuse to invest in a security that has resulted in a loss in the past.

The framing relies on seeing only one side of the issue. Habits  heuristics consists of taking mental shortcuts. As for the factors cognitive, regarding comprehension, they differ based on the level of intelligence and education of each participant in the financial markets. Interpretation can, therefore, vary.

Regarding self-fulfilling prophecies, investors generally base their decisions on various analyses or advice found online, on the radio, on TV, from OPEC*, or from a friend. The investor then purchases a well-known stock and passes this information along to other investors. Consequently, the stock price rises. On a larger scale, analyses released by banks or financial institutions have the same impact.
Finally, the emotions from every individual (fear, greed, aversion, pride, desire, etc.), family situation, age, gender, or even sociability all impact the decisions made. Some people are more inclined to take risks, while others prefer security.