I find this a good depiction of mass human psychology in the stock market. Look at how most of the investors feel when they are riding up a bull run – “excitement”, “thrill”, and “euphoria”! Alan Greenspan would have called it irrational exuberance. It is indeed the greed and behavior of the investors that drove the price up into a self fulfilling prophecy – the share price is going up, let’s invest. The more money gets thrown into the market, the higher the share prices go. The masses continue to do it to a point that no more greed is able to sustain the run.
When the downturn begins, many (denial) investors will want to ‘believe’ they have made the right investments and will continue to ‘believe’ the stock will rebound. Often, they will call themselves long term buy and hold investors when they admit that a short term gain is not realized.
As the downturn worsens, “fear”, “desperation” and even “panic”, create another self fulfilling prophecy – the share price is falling, we need to sell. The more they sell, the more the prices will drop.
So how do you capitalize on market emotions? It really depends on what kind of investor you are. I believe there are 2 kinds of investors that will probably make the best out of such situations.
The first would be the value investors. The point where they are likely to make investment will be between “capitulation” and “depression”, also denoted in the diagram by “point of maximum financial opportunity”. The fact that I stated a region rather than a point is because I believe not all value investors are able to locate the point where market bottoms, and it would be already profitable by buying around the region of bottoms. Thereafter, they will wait out for the next bull run to sell for profits.
It is apparent that the person who came out with this diagram is a value investor since he feels that the maximum opportunity is at the bottom of the market. Trend followers on the other hand, would see opportunities throughout the cycle.
Trend followers would follow the crowd riding up the bull run. The difference between them and the mass investors is that they will liquidate their stock holdings when the market begins to reverse, while the mass investors will still hold on to their stocks. After confirming the downtrend is valid and strong, trend followers would short the market, making money as the stock prices go down. Hence, trend followers are able to make money in both up and down markets, bull and bear runs. Find out more about trend following here.