It’s important to understanding that traders have specific emotions which have varying magnitude. This understanding is critical to learning how either you or another investor might behave. There is a cyclic process of psychology that explains the relationship between our feelings and our judgments.
The knowledge of this cycle can help you very much in your own trading. Following are the main stages in the market emotion cycle:-
1] Optimism –
The average investor enters the market feeling optimistic. It all starts with a hunch or a positive outlook leading us to buy a stock. We generally expect things to go our way, or may also have high expectations for the returns they will experience. Here, we feel positive about our investments and the overall market.
Example – Period of year 2004-2006 was time of Optimism.
2] Euphoria –
At the top of the cycle is when investors experience euphoria. This marks the point of maximum financial risk but also maximum financial gain. Our investments turn into quick and easy profits, so we begin to ignore the basic concept of risk. We now start trading anything that we can get our hands on to make money. We fool ourselves into believing we can beat the market, we cannot make mistakes. Also, that excessive returns are ordinary and that we can tolerate higher levels of risk.
Example – Year 2006 -2007 was time of Euphoria
3] Fear –
Reality sets in that we are not as smart as we once thought. Instead of being confident in our trading we become confused. Many people will then start to act defensively. They may think about switching out of riskier assets to more defensive shares or other asset classes such as bonds. At this point we should get out with a small profit and move on but we don’t for some reason.
Example – Feb-June 2008 was time of Fear
4] Panic –
This is the most emotional period till now in the cycle. We are clueless and helpless. At this stage we feel like we are at the mercy of the market and have absolutely no control. In this phase of the cycle, the realities of a bear market come to the fore and an investor may become desperate. Many panic and withdraw from the market altogether, afraid of further losses.
Example – Sept 2008 – Jan 2009 was time of Panic
5] Depression –
We think to ourselves how we could have been so dumb. While the investor drowns in depression, the market hits bottom and gives way to a new bull. Some start to look back and analyze what went wrong. Real traders are born here, learning from past mistakes.
Example – Feb – Apr 2009 was time of depression
6] Hope –
We can still do this! As the market continues to strengthen, the investor is hopeful that the market will continue up. Eventually we come to the realization that the market actually does have cycles. We begin to start analyzing new opportunities. We start considering new investments. Also, our confidence about the market grows.
Example – May 2009 till Mar 2010 was time of Hope