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Human emotion and the markets

Lesley Beath  |  14 Jun 2016Text size  Decrease  Increase  |  

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Over the next few weeks we will be looking at something a little different. Hopefully, it will be enlightening.

With the rise of self-managed super funds in recent times, more and more individuals are taking control of their retirement funds.

Some rely on financial advisers, some on services and websites such as Morningstar.com.au. Others may use a combination of both.

And yet others may decide to "go it alone," making their investment decisions based on their own research, and at times, their gut feel.

Whichever the method, the individual will be fully or partly responsible for their future financial situation.

The hardest part for the individual investor is to be able to make clear decisions without human emotion overriding their ability to make sound and timely investments.

There are no easy answers and no foolproof methods but by understanding what is happening around us, and within us, we might gain some insight.

So let's take a look at human emotion, as it affects the financial markets, and as it affects our ability to act rationally.

We will start with emotion in the markets.

I often talk about human emotions in regard to the financial markets, and what a significant role they play.

Chart patterns as they exist are not some fanciful imaginings of the technical analyst--they actually represent the human feelings of fear, greed and indecision.

Trends also incorporate these sentiments as they evolve.

Technical analysis is basically the analysis of human mass psychology. The world around us is constantly changing but the one thing that doesn't change is human nature.

Understanding human behaviour is a key to understanding the financial markets.

Chart patterns, apart from reflecting human emotion, will also reflect what is actually going on.

For example, if a particular stock, or the broader market is in an accumulation or distribution phase, patterns such head and shoulders tops and bottoms, doubles tops and bottoms, and rounding tops or bottoms are common.

These patterns can form as trends are changing. These patterns can also reflect indecision by some investors as the "smart money" enters or exits the market. and the not-so-savvy investors buy at the top or sell at the bottom.

You have probably heard of "rising wedges" and "falling wedges". These often occur at the end of a trend. Those patterns reflect greed (rising wedge) and fear (falling wedge).

As the trend unfolds, you will find patterns such as triangular formations, or ranges, which reflect a period of uncertainty.

In the middle of a trend, when there is little confusion as to what the direction is, you might see "gaps," "flags," "breakouts" and "breakdowns".

There is no mistaking the trend and these patterns reflect excitement, if the market is rising, and despair if it is falling.

Horizontal support and resistance levels are also a reflection of human nature. They are simply levels at which a large number of investors/traders will buy or sell.

Once support levels are broken they will become resistance--the investor who purchased at support, believing that price would rise, will see the rally back to that level as an opportunity to sell, therefore breaking even on the trade.

The investor who sold at resistance, expecting price to drop, will feel regret at doing so if the price breaks that resistance.

They may re-open the position if and when price comes back to the level at which they sold. The old resistance then becomes new support.

All of that is relatively simple to comprehend. But the markets and their participants are far more complex than that.

Those patterns may be clear to some, but unfortunately a chart pattern, like beauty, is in the eye of the beholder.

And investors, as they become wrapped up in what is happening on a day-to-day basis, may not see clearly. Emotions can cloud the issue.

There is another way of looking at human behaviour in respect of price action.

This is not reflected in chart patterns, trendlines, or support and resistance levels. It has to do with the human perception as trends unfold, and pullbacks occur.

We all know that price doesn't move up or down in a straight line. In any trend, there will be distinct phases.

As I mentioned before, stages in a trend are often accompanied by well-known chart formations. But there are other subtle ways of trying to gauge what is the current stage of the trend.

This comes from the "feel" of what is happening. This is not related to trends or chart patterns, but to group psychology and its current status.

Rather than go into that now, I will present a visual description later on. Have a look at the chart titled "What does it feel like?".

I put that together about 20 years ago and nothing has really changed.

There are other emotions that come into play. They are not linked to typical chart patterns, but to the behaviour of the individual and how they make their investment decisions.

We will look at that over the next couple of weeks.

I'd like to emphasise that this report and the ones that will follow, are simply to provoke some thought about some of the complexities of the marketplace, and the complexities of human behaviour.

It's not meant to be a complete study by any stretch of the imagination. Just something to reflect on.

 

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To the extent that any content below constitutes advice, it is general advice (or, in New Zealand, a "class service") that has been prepared by Lesley Beath as a Morningstar authorized representative (ARN 469614) without taking into account your particular investment objectives, financial situation or needs. If necessary, you should consider the advice in light of these matters, consult with a licensed financial advisor, and consider the relevant Product Disclosure Statement (Australian products) or Investment Statement (New Zealand products) before making any decision to invest. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

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