Investors may Act on Emotion and this Leads to Panic
Momentum in the stock market is a powerful force, however it is often reflective of emotions more than logic. The evidence for this is played out every time the market experiences rapid growth or decline. Investors jump on the movement and provide it with energy to keep it moving in the same direction in the face of logic, which is often contrary to what is happening.
During the dot.com boom of the late 1990s, investors, seasoned professionals and amateurs alike, piled cash into the market was beyond any measure of rational investing logic.
Taking Stock Profits
When investors who had gotten in early should have taken profits and rebalanced their portfolios out of technology stocks did not, they lost all their profits and much more when the bubble burst. Likewise, during market downturns, investors frighten easily and dump stocks for “safer” investments such as bonds and cash.
More stocks are held in mutual funds than by individuals. When fund investors sell their shares, the fund manager must come up with the cash. If significantly more shares are being sold than new shares are being bought, fund managers have a net outflow of cash.
How To Avoid the Herd Mentality And Maximize Your Investments
To cover the negative cash flow, fund managers usually must sell shares of stock they hold, sometimes when they would rather hold the stock or buy more shares at depressed prices. This selling to redeem mutual fund shares simply drives stock prices down further, which frightens even more investors to redeem even more mutual fund shares and the cycle continues.
The cycle of market momentum is broken when net dollars begin flowing back into the market. If investors can make intelligent trading decisions during downturns and rebalance during booms, they will come through these market cycles in much better financial shape than if they follow the market herd.
The market herd (momentum) may be powerful, but it is often wrong.
Market Sentiment and Herd Mentality
What is Market Sentiment?
It is a measure of the general mood of investors as to the expected price direction of the stock market. Market sentiment is, in fact, one of the most significant factors that drive the short-term stock market price movements. Simply stated, rising prices would indicate a bullish market sentiment while decreasing prices demonstrate a bearish sentiment.
The overall market sentiment is determined through the analysis of factors that include market data, government reports, and national and world events and news.
Applying Sentiment in Technical Analysis
Whether the technical analyst is trying to find the top or the bottom of a market or identify a breakout stock, sentiment indicators are regularly employed in their efforts to quantify the current mood of the market. To monitor sentiment, analysts track various indicators including price and volume data, options ratios, short interest, advancing versus declining stocks, new highs v. new lows, news, and more.
Market Sentiment and Individual Stocks
Interpreting this information correctly is important as the expressions that often prove true are that “all boats float or sink with the tide” and “the trend is your friend”. The translation is that the price of an individual stock is more likely to rise if the market as a whole is in an upswing and falls during a downturn.
Market Sentiment and the Herd Mentality
The market sentiment is often seen as the current “herd mentality”, which is the tendency for individual investors to follow the actions of a larger group, regardless of whether these actions are logical. A herd mentality is driven by the belief that such a large group of investors could not be wrong.
Market Sentiment and Contrarian Investing
On the other hand, contrarian investors believe that sentiment should be viewed with an element of caution. For example, great optimism, as evidenced by the indicators, can mean that people are fully invested in the market. It follows that, with no more money available to continue to drive up prices, the uptrend must end.
Through this logic, traders reading into sentiment indicators may also conclude that very high levels of anxiety over the market can mean the market has bottomed out, and it may be time to buy.