If you’re new to the world of investments, you’ve likely heard the term “psychology of market cycle” thrown around a lot by many investors.
If you’re wondering what this means and if it has anything to do with the psychological state of the market cycle, then don’t look any further because we’ve got you covered!
Let’s start with the basics, which define what market psychology is in the first place.
What Is The Psychology Of Market Cycle?
Market psychology believes that a market’s movements reflect or are affected by its players’ emotional states.
It is one of the core themes of behavioral economics, an interdisciplinary study that studies the different elements that influence economic decisions.
Many people feel that emotions are the primary driving force behind financial market fluctuations. The general shifting investor mood causes the so-called psychological market cycles.
Market sentiment is the overall feeling that investors and traders have about an asset’s price action.
A bullish trend can be seen when the market starts to become optimistic and asset prices begin to rise; this is commonly known as a bull market. When prices continue to drop, it is called a bear market.
As a result, sentiment comprises the individual perspectives and sentiments of all traders and investors in a financial market.
Another way to look at it is an average of the market participants’ overall feelings. However, like with any organization, no single viewpoint is dominant. According to market psychology theories, the price of an asset changes continually in reaction to the general market attitude, which is likewise dynamic. Otherwise, making a successful transaction would be far more difficult.
When the market rises, it is most frequently due to an improvement in traders’ attitudes and confidence.
When the market is optimistic, demand rises while supply falls. As a result of the increasing demand, the attitude may become even more aggressive.
Similarly, a significant decline creates a negative feeling, decreasing demand while increasing accessible supply.
The only dynamic you must learn is that single stocks and markets do not move in a straight line up or down.
They exhibit cycles in their upward or negative tendencies, which are critical to comprehend for anybody looking to invest directly in the stock market.
Markets and businesses will collapse from time to time, regardless of how fantastic the environment or the firms are.
Even when a company’s business performance is excellent, it is susceptible to market dynamics.
What Are Market Cycle Phases?
No matter which market you refer to, it all goes through the same phases and is cyclical. When one market cycle concludes, the next begins.
The issue is that most investors and traders fail to comprehend that markets are cyclical or fail to anticipate the conclusion of the present market phase.
Another big issue is that even if you accept the existence of cycles, predicting the top or bottom of one is practically impossible.
However, knowing cycles is critical to optimizing your investment or trading profits. Here are the four key components of a market cycle and how to identify them.
There is excessive optimism as the market has remained stable for some time and is starting to rise. The early majority has jumped on board, and behavioural economics comes into place.
This group comprises asset classes that can identify that the market behaviour and sentiment have shifted when the market makes higher lows and higher highs.
Although media sources begin to speculate that the worst is gone, unemployment continues to climb, as do rumours of layoffs in various industries.
As this stage progresses, more investors join the bandwagon as fear of being left out of the market is replaced by greed and fear of being left behind.
As this phase comes to a close, the late majority enters, and market volumes begin to rise significantly.
At this time, the financial markets are supreme, and the market cycles cause them to remain so. Values go well above historical standards, and logic and reason give way to greed.
The wise money and insiders are dumping while the late majority is buying in. However, when prices begin to level out, or the climb slows, laggards who have been sitting on the sidelines perceive this as a buying opportunity and rush in.
Prices make one final parabolic surge, known in technical analysis as a selling climax, during which the highest gains in the shortest periods frequently occur.
However, the cycle is ending, and the market has started falling again.
This is the most unpleasant cycle stage for individuals who still retain positions. In this phase, the market experiences sideways movements.
Human emotions are at an all-time high, and price movements are erratic. Different markets may experience this in different ways.
Many people cling to their investments because the value has plummeted and when prices drop a lot of market sentiment is created when investors refuse to let go.
Only until the market has fallen by 50% or more do the laggards, many of whom purchased during the distribution or early mark-down period, give up or succumb.
Unfortunately, this is a buy signal for early adopters and indicates that a bottom is near.
However, new investors will purchase the depreciated investment during the next accumulation period and reap the benefits of the next mark-up.
Sellers begin to dominate the market in the third stage of the market cycle. They are completely dominant, increased demand, and investors have started putting their money on the table.
This market cycle phase is distinguished by a period during which the preceding phase’s bullish attitude transforms into a mixed sentiment.
Prices are frequently trapped in a trading range that might linger for several weeks or even months. It’s a tough time, but investment decisions need to be quick.
On the other hand, the distribution phase might come and go rapidly. When this phase ends, the market reverses course.
Movements that occur during the distribution phase include classic patterns like double and triple tops and head and shoulders patterns.
The distribution phase is extremely emotional for the markets, with investors seized by periods of utter terror intermingled with hope and even greed as the market resumes its upward trend.
Many issues have exorbitant valuations, and value investors have long been on the sidelines.
Normally, attitude shifts slowly but steadily, although this process might be hastened by an unfavourable geopolitical incident or terrible economic news.
Those who cannot sell at a profit accept a breakeven price or a slight loss.
After the market has bottomed, innovators such as business insiders and a few value investors and early adopters such as clever money managers and experienced traders begin to purchase, believing the worst is past.
At this point, values are highly appealing, yet the market sentiment is still gloomy. This phase carries maximum financial risk because of uncertain market prices, interest rates, and negative sentiment.
Articles in the media predict doom and gloom, and some who were long through the worst of the bear market have recently given up and sold their remaining shares in disgust.
However, prices have flattened throughout the accumulation period, and for every seller who throws in the towel, someone is there to take it up at a nice bargain.
The market’s overall attitude begins to shift from negative to neutral.
How Do Investors Take Advantage of Market Psychology?
Assuming the notion of market psychology is correct, knowing it may assist a trader in entering and exiting positions at more advantageous moments.
In contrast, the maximum point of financial danger frequently occurs when most market participants are ecstatic and overconfident.
As a result, some traders and investors attempt to read a market’s emotions to identify the various stages of its psychological cycles.
They should ideally utilize this knowledge to purchase when there are lower prices and sell when there are higher prices. In reality, however, identifying these ideal places is rarely simple.
Cycles exist in all markets, even though they are not always visible.
The accumulation period is the moment to purchase wise money since prices have stopped dropping and everyone else is still bearish.
These investors are also known as contrarians since they are betting against the current market mood.
These same individuals sell as markets reach the last mark-up stage, known as the parabolic or purchasing climax.
When values are rising, the quickest and mood is the most positive, indicating that the market is about to reverse.
Smart investors who understand the various stages of a market cycle are better prepared to profit from them.
The majority of traders and investors agree that psychology influences market prices and cycles.
Although psychological market cycles are well understood, they are not always straightforward to manage.
Even experienced traders have struggled to separate their emotions from the market mood.
Investors must understand the market’s psychology and psychology and how it influences their decision-making process.