Why is Investing Psychology Crucial in Stock Trading?

For every item in the world, there are two prices. One is the actual intricate price of that item and the second one is the perceived price or the imaginary price that we impose on that item. The financial assets are also guided by these two pricing principles. For example, the intrinsic price of a stock of a company is based on the financial strength of the company at any given moment. Thus the various financial data such as balance sheet, profit and loss account, net profits or loss, earnings or loss per share, cash flow, funds flow, dividends, bonus stocks, reserves, etc. should be the determinants of the intrinsic price of the stock.

On the other hand, the market price or trading price of the stock is determined purely by supply and demand conditions that are driven by investment psychology of the market participants. The investors bring with them various psychological factors and individual sentiments. Issues and dynamics of human mind involve several complex aspects like greed, fear, enthusiasm, anxiety, panic, etc. All these factors of investment psychology play a crucial role in deciding the perceived value of the different financial assets. This psychological influence on the financial markets is the driving force behind the fluctuations in the markets. Due to the constant change in these psychological factors in the minds of investors and conflicting emotions operating at the same time, the behaviour of the markets invariably become volatile and unpredictable.

There have been two major schools of thought to explain investment psychology. Professor Eugene Fama of the University of Chicago advocated “Efficient Market Hypothesis (EMH)” in 1969. He stated initially that efficient markets adjust rapidly to all the new information that influences the markets but later modified his definition of EMH in 1991 and stated that asset prices reflect all the information available in efficient markets. On the other hand, Richard Thaler and Werner De Bondt propagated “Behavioural Finance Theory (BHT)” in 1985. However, Thaler also changed his concept in 1999 by submitting an article, “The End of Behaviour Finance”. Since both these major concepts have undergone changes within a few decades, it is obvious that the determination or analysis of investment psychology is much more complex than what we can normally assume.

The price movements of financial assets are basically determined by the expectation or fear in the minds of investors. The supply and demand is influenced by these psychological factors, with the investors either pumping money into certain assets or withdrawing money from other assets. Even though all of us are fully aware that the intrinsic value of the assets never undergo any sudden changes unless major fundamental factors impact them. Still, the perceived psychosis makes us impose arbitrary values on these assets.

We never try to have a solid plan of approach to trading in financial assets. The great investor Warren Buffett stated, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful”. Still, most of us fail overcome our sentiments. We also go by the herd mentality of buying when everyone is buying and selling when selling is the trend. These are the kind of investment psychology attitudes that brings us down in financial markets and leads to financial failures and losses of investment.