Wednesday, 14 April 2010

Herd instinct - This is probably the most important concept that you need to know about market psychology.

You do not need a degree in psychology to understand that in the short run, the price of a stock can deviate substantially from its basic value because market participants may betray a herd instinct in their behaviour.  This is probably the most important concept that you need to know about market psychology.  

  • When people do not understand a company well, they follow the crowd:  
  • They chase the winners and dump the losers indiscriminately.


Because of this herd mentality, individual stocks - and the entire market - may go up or down dramatically.  Herding stems from greed or fear.  

When interest rates rise or when there are fears that an important country's economy will falter, world markets react substantially.  It is extremely difficult to time the market or to forecast events that make markets move dramatically.  The lesson to learn is that when the market does go down significantly, prime buying opportunities may surface.

Do you know whether you have the herding instinct?  It's a good idea to find that out if you can.

  • The most common phenomenon I have observed is that people feel like buying a stock when its price has recently gone up or when the market has gone up.  If you do so without evaluating the company, you are probably herding.  
  • Do you evaluate the price increase in a logical manner?  You are probably not herding if you compute a stock's intrinsic value before you make a buy or sell decision.

Related:


Comparative Qualitative Analysis of Glove Companies

Look at these charts.  At the beginning of 2010, all the prices of these glove companies climbed exponentially reaching their peaks.  These were evidence of herd instinct driven by greed.   Recently, the sector was downgraded and the great, good and gruesome glove stocks were sold down driven by fear.  This was yet evidence of herd instinct.  When people do not understand a company well, they follow the crowd, chasing the winners and dumping the losers indiscriminately. 

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