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Some of the psychological effects that are related to
market bubbles are herding, overconfidence and playing with house money. Herd mentality, in the context of finance,
relates to the investor's decisions being influenced by actions of other
investors, which often leads to dominance of emotional feelings over rational
thinking. The most recent example of
herd mentality would be the mini bubble in alternative energy sector that took
place during 2007 when stock prices for solar stocks skyrocketed by more than
100-200% within a year. In this case investors who got into the sector at the
end of 2007 under the influence of media coverage and seemingly never ending
increases in stock prices, got burnt in the beginning of 2008 when solar stocks
nose dived in conjunction with a broader market correction. Interestingly herd
mentality takes place not only during bubbles but also during crashes. When the
stock market goes up, following the herd fuels stock buying and drives the
market even higher. During market crashes, herd mentality leads to the market
falling even lower. Another factor that may contribute to market bubbles is overconfidence. Overconfidence corresponds to investors'
feeling of superior knowledge and market timing. According to Robert Shiller, author of Irrational Exuberance, overconfidence leads to high trading volume
and contributes to market bubbles. Another contributing factor to market bubbles, are investors who
realized profits from one stock and subsequently treat this profit as ‘house
money', and are willing to take on more risk.
Some of the psychological
effects that occur during a market crash are termed the disposition effect and
snake bite effect. Disposition effect occurs when investors sell stock that
appreciate in price too soon, and tend to hold on to stocks whose price dropped
down for too long. This effect not only
reduces the amount of realized capital gains, but also increases the amount of
taxes investors have to pay as unrealized capital losses are not used to offset
the realized gains. Hence the Wall Street adage: Hold on to your winners and
get rid of your losers. As mentioned before, herd mentality leads to market
freefalls when selling leads to more selling. Snake bite effect relates to
investors' avoidance of stocks that led to financial losses in the past. For
example, investors who lost money during the 2000 market crash may avoid
investing in technology stocks, even if valuations of these stocks fall to
attractive levels.
We hope that by understanding the emotional factors that
influence investment actions, investors may be better equipped to handle stock markets'
ups and downs.
Olga Peram is Director of
Analytics at Fundata Canada Inc, a leading source of Canadian mutual fund
information. For more information, please visit www.fundata.com.
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