Investment is conducted in markets with many other participants. An understanding of the psychology of the market participants is important.
Herd mentality is the most prevalent aggregative psychological reaction of market participants. It refers to the primitive reaction of market participants to follow the action of the majority usually reflected in the price of the securities. Herd mentality manifests to the extreme in market mania and causing harmful bubble and subsequent bust. However, to cool headed observers the herd mentality is also useful: it is one of the reasons behind trends in various markets. As we discussed in investment methods, one can take advantage of market trends using either trend following methods or contra-trend methods. A direct gauge of the aggregative market psychological status is the psychological index maintained by market intelligence.
On individual level, it is hard not to be influenced by various emotions if one is intimately involved in market actions. This is especially true for frequent traders. A certain harmful behaviors are well known to both researchers and practitioners. For example, disposition effect is observed both in laboratories and in markets: people by nature dislike lose and the primitive tendency is inclined to take small profit but paralyzes when a position incur large losses. Perhaps because the majority market participants behave this way it is the opposite that makes money and thus the proverb “cut your losses and let your profit run’’. Another adverse behavior is the gambler’s mentality: inexperienced traders often increase their position sizes when experiencing a losing streak in the hope to get even quickly. The result is often disastrous.
To guard against these fallacies it is often helpful to establish rules. It is also helpful to try to be detached from the emotions coming from intimate involvement from the markets. It helps to observe that if a trader has developed a well though through strategy. Then it shouldn’t take him/her long to perform the daily routine of executing the strategy. If you are watching the markets longer than that then you should ask the question why?