Unpicking the psychology that drives stock market trends

Extravagance and optimism are the axioms of a bull market, which occurs when stocks rise more than 20 percent from their 52-week high and continue on that upward trend. Investors enter a state of irrational exuberance, whereby stocks have risen in price for so long they believe that they will never stop rising. This then creates a self-fulfilling prophecy: investors bid prices way above the stock’s underlying value, the stock price soars due to perceived demand, and the cycle begins again. Bull markets only occur in a healthy economy, and are usually triggered by top-line revenue growth as measured by GDP or substantial profit growth by key market players.

By contrast, a bear market is categorised by caution and restraint; it begins when stock prices have fallen more than 20 percent from their 52-week high, and continues until the trend is reversed. Bear markets have occurred 32 times between 1900 and 2008, about once every three years, and typically last just over a year. Bear markets can be caused by stock market crashes, or occasionally by market corrections. While shrewd investors recognise that corrections are a natural part of any stock cycle, as they allow consolidation before the market goes on to reach higher highs, they can also trigger panic for less experienced market players, who then unwittingly send the market crashing downwards by panic selling.

Evidential proof
Within economic circles, the current state of the market and whether it will subsequently transform into either a bear or a bull is a constant source of debate. Many analysts argue that we’re currently in the longest ever bull market, which began in 2009, but it’s currently teetering on the brink: in December 2018, the S&P 500 came within two points of entering official bear territory, according to CNN. Nobel Laureate Robert Shiller told press at Davos in January that there is a very real threat of us entering a bear market in 2019; others have argued that we’re already there.

The endless opining as to whether the market is currently a bear or a bull can, ironically, cause it to switch from one to the other, due to the psychological phenomenon of herd mentality. This is commonly defined as the tendency for people’s behaviour or beliefs to conform to those of the group to which they belong, and is well documented among the investment community. In a bull market context, it typically stems from an assumption that others around you know something you don’t, and by not following their lead, you risk missing out on a great opportunity. Similarly, in a bear market, it’s triggered by other investors around you pulling out – you assume they have the inside track on information about a company’s future, and you decide to retract your investment too.

Osborn believes that herd mentality is more likely in a bear than in a bull market. “Stampedes occur when panic and fear set in – they’re much stronger emotions than the joy associated with getting rich,” he told World Finance . “When people start losing money, that’s when they run for the door.” However, there are examples – albeit fewer of them – of upward stampedes in stock markets, one of which being the 2000 dotcom boom. The realisation that the internet could be monetised triggered a mass influx of investment into fledgling online companies. Many transpired to be hopeful speculation, as the sector was very much in its infancy and failure was common. As such, investors that had hoped for huge wins were left wanting.

A split second
While herd mentality is by no means a novel phenomenon, it’s perhaps surprising that it continues to play a significant role in stock markets today, given that so much of trading is now computerised. But, Osborn said: “Automated systems are still programmed by human beings; at the end of the day, the decisions that are being made, and the price action that causes someone to sell, are exactly the same.” However, he explained, automation has significantly sped up the pace of that decision-making process by squashing a day or a month’s worth of activity into a minute or an hour. “All that automated trading does is accentuate the speed of the inevitable herding behaviour,” Osborn added.

Posts such as this, shared without contextual data and perhaps without consideration for market impact, but rather in a show of political bravado, can send markets soaring up and down in an instant, wiping out hard-won investor gains. While it is well documented that political instability often spills over into markets, previous figureheads have mediated their communications to ensure that dramatic swings such as those caused by Trump’s tweet are limited – something the current president has declined to do.

Prominent business leaders have also triggered significant market moves through imprudent social media posts. On August 7 last year, Tesla founder Elon Musk tweeted that he had secured funding to take the company private at $420 a share. Prices skyrocketed to $379 on the stock market, before crashing back down to $322 on August 24 when the original post was revealed to be erroneous. He was later fined $20m by the Securities and Exchange Commission for the “false and misleading” post.

The fact that these two high-profile figures were able to share uncontextualised, histrionic and incorrect information in a public forum in a matter of seconds triggered investors to act, herd-like, in a way that they may not have done had the information been shared in a more measured way, or in a different format. “Instead of reading newspapers and taking a day or two to absorb financial information and react to it, [that process] happens instantaneously on social media,” Osborn explained.

The game of trust
Both incidents, and others like it, have raised the question of trust – an ever-declining commodity in our digitally driven world. Herd mentality inherently relies upon trust, in that the initial market move is triggered by a leader or source of some kind, whose information is considered reliable and therefore worthy of being acted upon. This could be a small news item or a comment by a seasoned investor like Warren Buffett that inspires perhaps five percent of investors to sell, in turn triggering others to follow suit.

On social media platforms, this has the potential to be exploited. “There’s a lot of uninformed people [online] who don’t necessarily have the understanding to accurately interpret information,” said Osborn. “The ‘clever’ people with a big audience can push the markets around by putting comments out on social media – not necessarily false news but perhaps accentuated a little, to push a share price in a certain direction. Because they know they have an audience, that’s a very easy way for them to disseminate information to people and get the result that they wanted very quickly.”

This exploitation of trust is now an entire business model in itself for so-called ‘social trading platforms’, such as eToro. These firms allow novice investors to peg their trades to those made by seasoned professionals, allowing them to ride coattails when prices go up. While it has certainly made trading more accessible, it can also be dangerous, as it allows any member of the public to integrate themselves into an industry of which they have no knowledge and end up blinded by dollar signs. Career investors will understand that it’s possible – even probable – to have a few months of five percent gains before losing 10 percent in a single month – most will expect that kind of fluctuation. For those unaware of these oscillations, they’re more likely to pull funds out the second they risk losing a penny, which in turn can trigger dramatic market moves. “I can totally understand why people [use these platforms], but their naivety makes them react in a knee-jerk way,” Osborn told World Finance .

Looking ahead
The current investment climate, with all of its confusion surrounding reliability, is symptomatic of a wider issue at play: that of perspective. The rapid dissemination of online information, together with the emergence of new technological players that soar to the top of markets in no time at all, drives markets forward at a pace that’s challenging to keep up with. This, together with the long-running debate as to whether the market is a bear, a bull or something teetering on the brink between the two, means that less experienced investors can rush into trading decisions due to fear of missing out on a gargantuan pile of wealth.

Herd mentality continues to play a significant role in stock markets today

In reality, both bear and bull markets – and all the swings that occur within each of them – are part of an overarching business cycle driven by global socioeconomic factors outside of any individual’s, or even country’s, control. This cycle, composed of a never-ending series of peaks and troughs – none with any fixed time frame – is the only market factor that is absolutely guaranteed to go up or down. It’s controlled to some extent by fiscal and monetary policy, but national market moves, currency crises, political revolutions and natural disasters could send the world soaring to a dazzling peak, or plummeting to a devastating trough.

“I think there is certainly over-optimism when people start to approach trading,” said Osborn, referring to the get-rich-quick motivation that can drive risky trading decisions. “In reality, if you look at the history, stocks generally go up over a long-term cycle.” Essentially, those making low-risk, stable investment choices now are likely to be in profit in 10 years time. While the explosion of tech stocks, the emergence of exciting start-ups and the rapid distribution of information via social media has driven a growing appetite for volatility-based trading, seasoned investors generally agree that it’s the few, not the many, who make money that way.

Ultimately, we’d all like to believe that we’re the exception, not the rule. In reality, there are very few people who accrue enormous wealth on a risky bet, and even then, much of that will be down to luck, not knowledge. While ‘everything in moderation’ might seem like a boring old adage, it’s also shrewd advice when it comes to choosing where to invest. By eschewing the herd and making low-risk, empirically driven financial decisions based on the understanding that a larger cycle is at play, investors can safeguard their finances for the future.