Although financial markets are often discussed through the lens of data (i.e., inflation prints, earnings reports, policy decisions, etc.), there is another element that affects each cycle. Human behaviour is always present beneath the numbers and contributes to the cycle of expansion and contraction.
Each cycle in the markets does not occur simply due to mechanical forces; the factors that contribute to each cycle include the collective expectations of the people in the market, the confidence that exists in the marketplace and/or the fear that is felt by those participating.
Martin Robinson, Director at Amzonite, with over a decade in markets and fintech, brings practical, seasoned views on the psychology of market cycles.
“If you examine the historical record of markets, you will soon realise that although the economic environment has changed, technologies have evolved, regulatory environments have improved, the human aspect of the economy has remained relatively unchanged.”
Understanding the psychological factors that influence the cycle of the markets does not involve predicting the next time the market turns; understanding the psychological factors that contribute to the cycle of the markets involves recognising the repetitive emotional patterns that exist in the behaviour of people in the market that cause the markets to go up and down, expand and contract.
In the early part of each cycle, recovery in the market is generally slow. At first, many do not believe that the worst is behind us. There is a gradual rebuilding of confidence in the economy. As we see stability in the economy and as values appear reasonable in comparison to the previous lows in the market, many start to participate again in the market. When stability in the economy continues and optimism develops, the market's volatility decreases, and investor's risk tolerance increases.
“At the beginning of each expansion, investors can be sceptical about the future. Once gains build and uncertainty fades, confidence becomes widely accepted.”
In the beginning of each cycle, investors are typically disciplined in their decision making. However, as positive trends develop, investors' behavioural tendencies begin to surface, or the belief that the trend will continue indefinitely based on the recent past.
Market peaks are not usually recognised as such at the time of occurrence. Instead, a series of subtle changes often precede a market peak, tighter liquidity, shifts in the tone of policy makers, slowing growth momentum, etc.
At this point, the sentiment in the market begins to fracture. Confidence is no longer building in unison. Volatility increases in the market.
More importantly, markets are always looking toward the future. Therefore, the primary driver of market movement is not the confirmed outcome of current data, but the changing expectations of the market participants.
“It is usually the change in expectations that drive the market movement, not just the data itself.”
Loss aversion plays a major role in influencing the behaviour of investors in bear markets. Fear, loss aversion and a shorter time horizon are common characteristics of bear markets. Investors will frequently look at their long-term goals through the prism of short-term pain and distress.
As volatility increases in the market, the uncertainty that exists becomes the prevailing emotion of the market. The selling that occurs in the market can become indiscriminate.
“Fear changes perception. Risks that appeared to be manageable six months ago can suddenly seem completely unbearable.”
It is during these periods that the extremes of the narratives in the market are often developed. Pessimism may dominate the discussion surrounding the market. Historically, however, the pull back phases in the market represent a normal structural component of the market system and are not an anomaly.
Cycles in the markets will continue despite the rapid evolution of technology, increased availability of information, and improvements in regulatory environments. The primary reason is that there is a predisposition in all humans to show bias, overconfidence, anchoring, recency bias and herding behaviour, to name a few examples.
“The availability of information did not remove cycles; if anything, faster information could facilitate quicker emotional reactions.”
Because the structure of the market evolves over time, the behavioural response of investors remains relatively consistent. The consistency of the behavioural response of investors is the primary explanation for why historical market cycles can appear similar when analysed using a psychological model.
Understanding the psychology of market cycles does not guarantee the elimination of volatility in the market, nor does it guarantee the ability to predict the exact timing of market peaks and troughs. Understanding the psychology of market cycles provides investors with perspective.
Understanding that optimism, fear, and uncertainty are recurring elements of the behaviour of investors in the market allows investors to view the volatility experienced in the market as part of a larger cycle rather than an isolated event.
“Markets are rarely linear. They tend to follow a sequence of phases influenced by emotions and economics. The difference between these two allows for a more rational evaluation of both the positive and negative phases of the market cycle.”
Investors have learned through the years that the enduring nature of cycles in the markets is directly related to the enduring nature of the behaviour of investors. While data drives the markets, the emotional response of investors to the data drives the cycle of the market.
Awareness of this relationship is likely one of the most enduring insights in the world of finance.
Managed investment funds can function as organised structures that enable investors to navigate through the complexities of the markets. By contrast to individual investor decision making, managed investment funds are typically established within a defined mandate, governed by formalised standards, and operate with a risk management framework.
“One of the biggest issues for individual investors can be distinguishing between the emotional decision to buy/sell and the rational decision to buy/sell,”. “Investment structures are created to operate in a disciplined manner, especially in times of high volatility.”
No structure eliminates market risk. Nevertheless, structured processes, oversight mechanisms, and long-term perspectives can significantly enhance the probability of rational decision making that is not driven by sentiment. In cyclical markets, process consistency can be as important as the market outlook.
At Amzonite, we specialise in helping private investors navigate this complexity, bringing institutional-grade insights to those ready to take a more intentional approach to wealth, via our managed investment funds.
Disclaimer: This content is for informational purposes only and does not constitute financial, investment, or legal advice. Past performance is not indicative of future results, and all investments carry risk. You should always conduct your own due diligence or consult with a qualified financial advisor before making any investment decisions. Amzonite does not provide personalised financial advice and any strategies mentioned are illustrative and general in nature.
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