The scholarship, psychology: a link?

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The stock market is an important sector for any state. It consists of a set of rules and mechanisms for the sale and purchase of securities. The main factors influencing stock market activity are:

  • Supply and demand

  • The situation of adjacent markets: the stock market is part of the financial market and is influenced by other related markets (foreign exchange market, financial services, etc.)

  • Subjectivity: the behaviour of certain influential persons affects the behaviour of other financial market entities and thus the volumes traded.

The basic rules of the stock market and the psychology of the participants have been studied by many scientists. These rules can be summarized as 4:

Rule 1 : The market anticipation. The stock market anticipates the state of the economy. This was confirmed, for example, two years before the 1929 crisis, when some consulting firms were already recommending that investors shorten their shares. However, although the forecasts were very pessimistic, the market continued to grow, up to crack.

Rule 2 : The stock market is irtional. The 1626 crack in Holland is an excellent example of the irrationality of investors. Despite the hysteria that had precipitated a nationwide drive for wealth followed by bankruptcy and recession, the object of investment was not shares, bonds or commodities. They were tulip bulbs. It was prestigious for the nobles and bourgeois to have tulips of several varieties. It is said that a rare bulb of a certain variety was even exchanged for several loads of grain, several pigs, several cows and beer barrels, etc. The average person would start selling their assets in order to invest in this new and flourishing market. One day, the majority began to doubt the real value of these bulbs. The market began to fall, countless people went bankrupt, and a recession followed the hysteria.

The stock market is able to react very quickly to facts, to news. But it can also be subject to subjectivity, emotions and constantly changing tendencies. Sometimes prices can vary depending on the financial situation and interests of investors, wandering between hysteria and indifference. Some investors – even reasonable ones – can indeed behave absurdly.

Rule 3 : The stock market is i>chaotic. Macroeconomic forecasts are very inaccurate. All economic interconnections are able to influence small but significant factors. No one can predict this perfectly. As stated in Chaos Theory, a complex dynamic system is very sensitive to initial conditions. We speak of the “butterfly effect”, where a flap of butterfly wings in Brazil could cause a tornado in Texas, or a grandmother who sold shares to Brussels could cause a financial collapse in Japan. Therefore, trying to predict a long chain of events or give quantitative long-term forecasts may seem absurd.

Rule 4 : Les technical analysts> use graphic indicators to analyze the stock market. If many investors use the same technical indicators, the graphs can be self-replicating. An investor can therefore make a profit, whether he is right or not.

Scientists have identified 2 groups of behavioural factors that can influence investor behaviour and the stock market:

  • Emotions. Many financial decisions are based on emotions (impulse, intuition, etc.) rather than rational calculations. As emotions arise spontaneously and unconsciously, it is very difficult to neutralize their impact.

  • The cognitive processes. Heuristic simplifications” lead investors to simplify their decision-making process.

The most powerful emotional factor influencing the decision-making process is investor confidence.

Emotions can lead, on the one hand, to an investor underestimating the probability of marginal events occurring and, on the other hand, to an investor overestimating the probability of continued growth of a stock market value.

Investors’ unfounded beliefs can be most devastating, leading to excessive trading volumes on the stock market.

Behavioural finance theory is gaining popularity and taking into account human behaviour and its impact on the stock market. Understanding the rules of behavioural finance that underlie investment decisions makes it possible to better assess the real situation of the stock market and thus to anticipate future changes in order to prevent the impact of negative factors.

What remedies do scientists propose to control overconfidence? We will see this in a future article.

Sources :

  1. The psychology of finance / Lars Tvede

  2. La finance behaviourale / Amos Susskind/

 

Camille Girard

Camille GIRARD


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