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Trading Psychology,
The 14 Stages of Investor Emotions |
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reprinted with permission from the
author Sean Hannon,
CFA, CFP
website:
http://www.epicadvisorsllc.com |
Efficient markets are
based on the assumption that rational people enter transactions
with the intent to maximize gains and minimize losses. While
this theory is sound, most investors are not the purely rational
robots that efficient markets rely upon. Instead, emotions often
cloud our decision-making and prevent us from acting in a
rational manner.
Knowing we can never conquer our inherent emotional biases, we
should seek to understand the range of emotions we may
experience as investors and how it affects our interactions with
the market. A common market psychology cycle exists that shines
light on how emotions evolve and the effect they have on our
decisions. By understanding the stages of this cycle, we can
tame the emotional roller coaster.
The fourteen stages are:
1. Optimism – A positive outlook encourages us
about the future, leading us to buy stocks.
2. Excitement – Having seen some of our initial ideas
work, we begin considering what our market success could allow
us to accomplish.
3. Thrill – At this point we investors cannot believe our
success and begin to comment on how smart we are.
4. Euphoria – This marks the point of maximum financial
risk. Having seen every decision result in quick, easy profits,
we begin to ignore risk and expect every trade to become
profitable.
5. Anxiety – For the first time the market moves against
us. Having never stared at unrealized losses, we tell ourselves
we are long-term investors and that all our ideas will
eventually work.
6. Denial – When markets have not rebounded, yet we
do not know how to respond, we begin denying either that we made
poor choices or that things will not improve shortly.
7. Fear – The market realities become confusing. We
believe the stocks we own will never move in our favor.
8. Desperation – Not knowing how to act, we grasp at any
idea that will allow us to get back to breakeven.
9. Panic – Having exhausted all ideas, we are at a loss
for what to do next.
10. Capitulation – Deciding our portfolio will never
increase again, we sell all our stocks to avoid any future
losses.
11. Despondency – After exiting the markets we do not
want to buy stocks ever again. This often marks the moment of
greatest financial opportunity.
12. Depression – Not knowing how we could be so foolish,
we are left trying to understand our actions.
13. Hope – Eventually we return to the realization that
markets move in cycles, and we begin looking for our next
opportunity.
14. Relief – Having bought a stock that turned
profitable, we renew our faith that there is a future in
investing.
Individuals clearly follow this cycle in their decision making
process. Since broad indices like the S&P 500 are comprised of
the decision of millions of individuals, we should expect index
prices to track this pattern as well. If we are aware of the
stage of the cycle we are experiencing at a given point
in time we will have a greater grasp of how our emotions are
affecting our investment decisions. This knowledge will help us
manage our own investment portfolios as well as predict the next
step for the broad market.
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