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Sunday, January 23, 2011

Learning Corner : The Herd Mentality

Crowd Behaviours

Taken from : informedtrades.com

In this lesson you will learn how the marketrs are manipulated through some simple, yet extremely powerful, psychological factors.

People come to the markets hoping to catch some "easy money" or to "get rich quick". Sometimes it takes a lot of money, but it doesn't take much time to find out how wrong they are. Crowd behavior can help you a great deal in understanding how the markets really work. The markets trade on the sentiment of the crowd and the crowd's sentiments are based on emotions. In the final analysis, people trade based on one emotion: fear. The markets manipulate this emotion.

The term Collective Behavior refers to social processes and events which do not reflect existing social structure (laws, conventions, and institutions), but which emerge in a "spontaneous" way...Collective behavior, a third form of action, takes place when norms are absent or unclear, or when they contradict each other.

The crowd, or herd, or retail trader, has exhibited behaviours that have proven to be consistent over time. From the above definiton of Collective Behavior, these behaviours can be boiled down to two primary reactions to market changes: one is spontaneity, which is better defined as panic, and the other is confusion. Both are derivitives of fear and the product of being uninformed about the most important underlying process of market dynamics - psychology.

Greed leads to price chasing and over-trading. The crowd sees the market making a large move and they panic, fearing they will miss out on some quick, easy profits. As a group, they usually pull the trigger just as price has reached the top or bottom. Then they are confused why this keeps happening to them. They wait, watching the market move swiftly the other way and jump in again. Or, after suffering as losses mount, they get out only to see the market suddenly turn back, making gains in the direction they just exited and leaving them even more confused.

What is being referred to by "the Crowd" is the largest group of traders and, as a group they make decisions based on emotions. As a group they possess the greatest amount of capital (liquidity) in the markets and are the easy pickings for the professional group we'll be defining later as Smart Money (SM).

When comparing individual professionals to individuals in the crowd, the professionals have relatively enormous funds at their disposal. When comparing groups, the crowd has the greater amount of funds by far. Trying to control a market on a dollar for dollar basis would be futile for the professional. They don't have enough money to control a market, but they do have enough to cause psychological reactions in the crowd.

Anyone who is confused as to how the markets work is easily manipulated. Confusion feeds fear and fear breeds panic. Fear comes in two forms: the fear of losing money and the fear of missing out on a big move (greed). This works in every scale and time frame.

Charles Mackay's famous book, Extraordinary Popular Delusions and the Madness of Crowds, is a collection of stories about crowd behavior in the market place. The stories can be seen working on charts everyday. An enduring bull market leads the crowd to believe the trend cannot end. Such optimistic thinking leads the crowd to overextend itself in acquiring the object of the mania. Eventually, fear takes hold when they start to realize the market is not as strong as they thought. Inevitably the market collapses and the fear turns to panic.

This is the nature of the crowd: a collection of usually calm, rational individuals getting overwhelmed by emotions. Those who study human behavior have repeatedly found that the fear of missing an opportunity for profits and the fear of great loses easily outweight rational behavior. At its fundamental level, these fears consistently overwhelm the crowd.

"Perhaps never before or since have so many people taken the measure of economic prospects and found them so favourable as in the two days following the Thursday [24th October 1929] disaster". J.K.Galbraith - The Great Crash 1929. However, "On Monday the real disaster began".

The disaster of 1929 continued down, then up; horror, then hope, then horror, for 6 months. It sunk the bulls, the speculators, the bottom fishers, the momentum trackers, the chartists, the value investors - everyone. Virtually no-one who had ever been involved in the markets came out of the other side with any money at all.

It is crowd psychology that forms the basis of professional manipulation: selling when the crowd is buying and buying when they are selling. Professional manipulation could not work if the efficient market hypothesis were true, since prices would only be determined by fundamentals.

ThisMatter.com, in an article about market sentiment, describes it like this:

To explain these market dynamics, the market is conjectured to be primarily composed of 2 groups: informed players and the much larger group of uninformed players. The informed player is considered to be the professional, who understands the valuation of assets according to fundamentals, but the uninformed players have little or no understanding of asset valuation, and, thus, is not a factor in their buying and selling decisions.

There are also liquidity players, who are market participants that buy or sell, not because of market forecasts, but because of organizational objectives or because they need the money, as when a pension fund needs to make payments to retirees or a mutual fund needs to sell to pay for redemptions, However, liquidity players are not thought to have a significant effect on prices most of the time, because their actions, motivated by individual needs, are not concerted.

Since the uninformed masses are a much larger group, they also have more money, and, thus, are a more important determinant of market prices. Hence, because market sentiment seems to be more important in the pricing of securities than fundamentals, a trader who accurately forecasts market sentiment will be more successful than one who only considers fundamentals. In this way, even informed players are swayed by the crowds.

As you can see, crowd behavior is no secret to the professional trader. The crowd still reacts to the market based on their emotions of greed and fear - and the professionals use this against them. For the professional, profits come, not so much from market analysis and technical indicators, it comes from manipulating the greed and fear of the crowd.

copied by : TEH

1 comment:

Remnant 613 said...

sorry to hear of yr ailing dad. wish him well. glad to hear you're coping ok.. take care buddy...