The Psychology Behind Stock Market Fluctuations

When I studied the stock market at school, I believed that the stock price was mainly determined by its intrinsic value. However, when I began my investment journey, I quickly discovered a different reality. Many stocks are significantly overvalued, while others are deeply undervalued. Fairly valued stocks, it seems, are quite rare. Numerous factors can cause a stock's price to deviate from its intrinsic value, and among them, psychology plays a crucial role.

Why does psychology have such a profound collective impact on the stock market? Investing is an action undertaken by human beings, most of whom are often at the mercy of their psyches and emotions. The desire for more, the fear of missing out, the tendency to compare against others, the influence of the crowd, and the dream of sure things are deeply rooted in human nature. The majority of stock market participants couldn't resist those emotional and psychological influences, creating waves of overvaluation and undervaluation that ripple across the market.

Greed drives people to hold or buy overvalued stocks, hoping there is still room for further appreciation and counting on it happening. Conversely, fear often triggers overreactions to market downturns, causing panic selling and stocks to be oversold. Additionally, the tendency to compare oneself to others (envy) compels individuals to disregard the logic and join in the frenzy of buying overvalued stock, simply because they've seen others profit from them. Moreover, the inclination to conform to the majority view, even when the herd view is cockeyed, often results in people following the market trend at the worst possible times. They become the last to buy into overvalued stocks and the last to sell undervalued ones, incurring losses throughout the cycle. When psychology and crowd influence move in, much of the time, the overpriced stocks are appreciating further, or underpriced ones are still cheapening. Eventually, these trends have a corrosive effect on investor's psyches, convictions, and resolve. As a result, when the right move would be to sell the former and buy the latter, many end up doing the opposite—driven by a mix of self-doubt and envy of others’ success.

To succeed in the stock market, it's essential to recognize and combat those psychology and crowd influences. First, having a clear understanding of the stock's intrinsic value allows us to identify when the stock is overvalued or undervalued, enabling us to do the right thing at the right time (sell high and buy low). In addition, developing an awareness of the market sentiment and having a sense of where we stand are equally important. By understanding the psychological forces driving the market, we can resist the temptation to join the frenzy of buying overvalued stocks and embrace the opportunity of buying oversold stocks. The market behaves like a pendulum, swinging through cycles marked by peaks and troughs. While we can’t predict the market’s exact movements, one thing is certain: market cycles are inevitable. Thus having a sense of where we stand within a cycle allows us to stay alert for occasions when a market has reached an extreme, adjust our behavior in response, and most importantly, refuse to join the herd behavior that renders so many investors dead wrong at tops and bottoms. Key indicators such as media coverage of stock markets, the current price-to-earnings (P/E) ratio in historical context, yield spreads, IPO activity, credit cycles, monetary policy, and interest rates can provide valuable insights into where we roughly stand within the cycle. Armed with this perspective, we can make more informed decisions and avoid costly mistakes driven by crowd behavior.

You need to have a strong enough stomach to defy conventional wisdom. The key lies in doing the opposite of the crowd—but with purpose. Simply following the herd exposes you to the risk of buying at market peaks and selling at troughs. Following the belief of herd and swinging with the market pendulum, will give you average performance in the long run and can get you killed at the extremes. To succeed, you must act contrary to the crowd, not just for the sake of being contrarian, but because you understand why the crowd is wrong. Only then you will be able to hold firmly to your views and perhaps buy more as your positions take on the appearance of mistakes and as losses accrue rather than gains.

The key to pursuing high returns without taking on excessive risk is to focus on buying cheap. This approach provides the best ratio of potential return to risk. The goal isn’t just to identify good assets but to find good buys. For example, while NVIDIA is undoubtedly a strong asset, with continuous business growth and solid profit margins, it may not be a good buy at the moment due to its high price. A good buy occurs when a stock’s price is relatively low compared to its intrinsic value, offering a margin of safety and better long-term potential.