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Understanding Markets

At Psychonomics we specialize in applying psychological knowledge to understanding financial markets. Consider: a market is in constant motion. At some points investor's actions may coincide while at other times they may not. Investors don't all act at the same moment with the same thought for the same reason. Uncertainty can cause investors to revert to instinctive behavior but not every investor is going to be affected to the same degree. Furthermore, small changes in prices don't always add up to big changes. There may be times when the market misses out a stage, dropping or rising at different rates. As a result, the markets can move differently even when the same circumstances reappear.

To trade successfully in this apparent chaos requires rationality. You need to be sure that your investment actions are going to have specific effects. The idea being that under condition 'A', action 'B' causes 'C'. With this in mind, your decision making can be improved by knowing the type of market you're dealing with. Psychological factors, such as sentiment, then feed into this process as well as interacting with external factors, such as economic and political uncertainty. In these circumstances, the job of Psychonomics is to identify the factors operating and to advise on investment decisions accordingly in the area of strategic change or portfolio rebalancing.

However, for those of you not too familiar with the operation of markets it's also worth keeping in mind that one of the biggest factors that effects markets is that there are short-term traders and long-term traders. It is these two types of trader and their actions that, more than any other reason, causes the market to fluctuate in the way that it does.

The short-term trader is usually a professional investor. This trader may be a portfolio manager but is more usually a currency, bond or commodities trader. Their investment horizon can be anything from a few months down to seconds. They are much more likely to base their trading decisions on technical analysis. As such, split second decisions to buy or sell are often taken as computer screens flash new information. They are less concerned with intrinsic or fundamental value than they are with instantaneous trends or exploitable technical anomalies.

The long-term trader is a different case entirely. This trader is concerned much more with fundamental analysis. Fluctuations during a day mean little to investment choice. The ups and downs of the market are factored in as the backdrop to informed decision when there are good opportunities for buying or selling. While the price itself does not need to be exact to be worthwhile. So a few points either way of the best price doesn't make a big difference to the decision to trade.

All these types of investor are important in the maintenance of a wide and sophisticated financial market. So that as long as there is a balance between all the different types of investor and trader, the market retains its liquidity and is stable. Hence a stable market is a dynamic market; one in which there is movement and volatility.

Anything that causes the balance to change between long and short-term traders will effect the market. In this scenario, the normal volatility that occurs never gets too far out of hand because there is always some other investor who will see these small rises and falls as a trading opportunity based on their personal analysis. The major swings - which are historically rare - occur when the actions of the majority of investors and traders become uniform. Uniformity therefore, represents instability in the market. Hence, investors discount potentially useful information in favor of short-term technical indicators or trends. They follow the herd and the predominant opinion rather that fundamental market or company information. Rationality and good sense gives way to instinct and financial survival.

Usually, the reason is that there is uncertainty about the future - it could be political, economic or social, and in fact it doesn't really matter what the prompt is. When market sentiment reflects a gloomy outlook, there is a mad rush to trade; investors want to get out before the barn door closes. Everyone tries to squeeze some profit from the market before it all turns sour. But not everybody can and there are bound to be some who cannot act fast enough. They are the ones trading - and losing - into a falling market that rapidly picks up momentum. With most people's natural inclination to believe that there is safety in numbers, the market quickly goes into freefall as greed turns to fear and panic. Even banks and brokers can fall prey to this phenomenon, and in situations like this our work centers on restoring a sense of rationality to the people involved.


What type of market are you facing?

In the wider context, the problem is that the political or economic backdrop is often very hard to relate to the financial markets; partly because of all the conflicting reports and media coverage that you hear. Taking an extreme example, on the latest news, the reporter states that the market's crashing. A little later, someone else says it wasn't a crash but a correction. Alternatively, another expert says we're still in a bull run. While, yet another expert says the market's turned. Overall, everyone has an answer to why the market is reacting as it is.

Confused? You can be sure the experts are too. So to clarify consider that other than the fact that crashes tend to be sudden and violent whereas corrections leading to bull or bear markets tend to happen several times - much like an earthquake is preceded by several small tremors - the difference between a correction and a crash is a matter of degree. Hence, uncertainty may give rise to a correction but when other factors are in existence, it could lead to a crash. The types of factors characteristic of market drops are:

  Strong concern about economic backdrop (such as: global market changes, interest rates, trade deficiencies, corporate earnings, loan defaults)
  Changes to dominant investment market - the fashionable area changes (for example, a major shift away from biotechnology stocks)
  Increased short-termism
  Increased short-term speculation
  Reduced long-term investment
  Changes in market procedures or the introduction of new technology for data handling or analysis

There may be other reasons that can be added to this list. However, what's important here is not the specifics but the fact that there is:

1.   Increasing uncertainty, such as financial, economic or political
2.   Increasing confusion about the course of future events or how best to manage the current situation
3.   Increasing conformity to the opinions of the investment crowd
4.   Increasing likelihood of personal misreaction to information.
In other words, investors haven't got the faintest idea what's going to happen. So no one's willing to commit themselves, other than to make a quick dip into market waters and then quickly out again. And magnify this to the extreme and you've got the recipe for a crash! Amid this dramatic cycle, it's easy to get caught out - or follow the herd because there's safety in numbers - and miss the best investment opportunities. Here, therefore, are a few common mistakes to learn to avoid and the reasons you might behave in this way:

When you miss the best time to trade
How you behaveWhy you do it

You become wedded to either a bull or bear market


There's psychological comfort in moving with the market


You break discipline and sell then get angry when the market continues on its original track


You alter your position in the market in the light of new 'expert' information


You buy more stock as it falls along with the market - averaging down


You believe this is how to get rich and forget an investment is only worth what people are willing to pay for it


The market moves against your expectations and you shy away from future trades


You forget that winning in the market is about getting it right most of the time


You won't accept the market has moved into a bull phase and keep selling stock you don't own - selling short (or buying risky put options, which give you the right to sell stock at a predetermined price within a specified period)


You're taking your revenge on the market for previous losses and believe, for no sound reason, you'll profit when the market falls


You're constantly trading on reported market swings. Losses and commission charges swallow the few small gains you make


Your strategy lacks discipline and consistency. You need to develop greater analytical objectivity.

The investment crowd and the media exerts a great deal of pressure on you to conform to the overall trend of the market. You move with the herd and the safety you believe it provides. The trick is to not be swayed by market sentiment. And this is all about developing a firm grip on reality; which means being aware of, and fully understanding, what's really happening in the market… not what everyone says is happening.










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