Fear and Greed – the Psychology Behind Momentum

I’ve talked a bunch lately about the power of momentum trends, and how it goes against our natural mean-reversion tendencies.  Today I read two articles which nicely enunciate the philosophy behind such movements.

First up, “Should I Sell My Silver,” from Tim Staermose.  Now – don’t focus on the “SELL SILVER” words – read what Staermose is telling you about the psychology that drives market pricing:

“It’s a cliché to say it, but ultimately all financial markets are driven by fear and greed. Actually, I’d argue that they’re driven almost exclusively by fear. Let me explain…

In the initial stages of a bull market, it’s the fear of the unknown that keep the masses out of an asset class. They think to themselves, “Yes. I can see it’s cheap. I can see the fundamentals stack up. But what if, blah blah blah. Why is no one buying it? There must be something wrong with it. Best to steer clear.”

For those who overcome this initial fear, or skepticism, and do get into the market, once it starts going up and they have a profit, once again their primary, over-riding emotion is fear… fear of losing their profits. Or, even worse. The fear of a profit turning into a loss.

So, what do most of them do? They sell out for a small profit. That’s why it is said that bull markets are constantly climbing a “wall of worry.” And that’s why ALL markets have corrections. Corrections happen when enough people are FEARFUL of losing the gains they’ve made so far, and start to sell out in large enough numbers to temporarily reverse the trend.

Near the top of a bull market, when most have finally overcome their skepticism, and the savvier participants have taken advantage of one of the numerous corrections to buy into the market, fear again comes to the fore.

For those not in the market yet, even at this late stage, what finally pushes them in is the FEAR OF MISSING OUT.

All their friends and colleagues are cleaning up in the market. How stupid they would look if they don’t get a slice of the “easy money” too. And so, they pile in like lambs to the slaughter.”

Staermose concludes that he doesn’t think we’re at this point yet in silver, although we’re definitely at the point where many people are fearful of losing their profits.  The entire piece is worth a read (although readers must be very careful using leveraged ETFs, as is suggested as a potential hedge).

A mere 5 minutes after I read Staermose’s eloquent enunciation of this topic, I read another explanation from Ivan Hoff: Why Momentum Investing is a Contrarian Approach:

“At the beginning of a new trend, there is usually an abnormal range and volume expansion. At this stage most market participants are reluctant to buy because the stock looks extended. The sudden change of the supply/demand dynamics often causes a “freeze” reaction = doing nothing. No one is willing to chase at this point, despite the fact that breakouts of long bases often precede much higher prices over time. The expectation of mean reversion is natural as it would restore the balance…

…The first major breakout is always considered an outlier and most market participants intuitively will desire to short it or simply will stay on the sidelines. At the beginning of a new major trend, people tend to under-react. As the breakout is followed by higher prices and more breakouts, more and more people become believers in the validity of the new trend and gradually the fear of missing out become stronger than the fear of losing. That fear of missing out has a particular name. It is called greed among independent investors and career risk among institutional managers. This is the time when the market start to proactively discount the dreams of the future potential.”

Ivan’s full piece is also well worth the handful of minutes it will take you to read.

Note the common theme: FEAR and GREED.  This was also my reply when a reader asked my on the Picasso post if there was a scientific reason for these trends.

-KD

 

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