How Investor Psychology Shapes The Stock Market

A graph showing the emotions that are often felt by investors during different times in the stock market.

When the average person is asked about the stock market, they think of fast and confusing charts, big numbers, and people sitting at computers pressing buttons and making millions at a time. This is why the popular assumption is that the stock market operates just on logic, data, and available financial information. While these factors certainly influence stock prices significantly, they aren’t the only forces at play behind market movement. Rather, there’s an overlooked factor: investor psychology. A great number of stock transactions are made by commoners and not experts, so human emotions like fear, hope, greed, and panic greatly shape the transactions made. This emotional influence helps explain why markets can be very unpredictable and why the everyday investor cannot make logical decisions. Understanding this psychology can give individuals a great advantage, since it lets them recognize emotional traps and avoid them.

Markets Aren’t Always Rational

The Efficient Market Hypothesis suggests that stock prices reflect all known information about a certain company, thus allowing investors to then make rational decisions using that. If this were entirely true, big market crashes and inconsistent price spikes would not occur because all investors would think critically and act accordingly. However, history shows that markets move irrationally a lot more than we think. Bubbles, periods when stock prices increase excessively, to a point much over their real value, are caused by investors chasing the prices because of hype. Crashes can happen when fear spreads, and because of this, investors sell rapidly, even if not much has changed regarding a company’s financial health. These patterns show that emotions, not logic, are often responsible for extreme market movement.

One of the most common psychological influences in the stock market is one called herd behavior. We follow this in many instances and not just in the stock market, but it usually happens subconsciously. Simply put, herd behavior is when individuals follow the actions of a larger group rather than making decisions with their own research or reasoning. If many investors start buying or selling a certain stock, others may assume that the group of people who are buying the stock know something that they don’t. Thus, they just add to the trend without verifying if it’s actually a good buy. A recent example of this is the GameStop stock surge in 2021. Thousands of people around the United States bought the stock purely on the basis that it was being discussed widely online. Most of them hadn’t even done an ounce of research when it comes to the company’s financial performance for the quarter. Nevertheless, prices skyrocketed because of the sheer number of buyers. Many of the investors who invested late because of excitement bought the stock at its peak price. Thus, when excitement reduced and prices fell, they had to take heavy losses. Herd behavior shows how easily social pressure can affect rational thinking in the stock market.

Dominant Emotions

The two most powerful and common emotions shown in stock market trading are fear and greed, and they are the leading causes for sudden, irrational selling or buying. Greed can drive investors to chase rising stocks and inflate the price even more, which often leads to buying a very overpriced stock, causing bubbles, which we briefly discussed earlier. Fear, often called the “opposite” of greed, makes investors hastily sell when prices are falling, which can lead to a widespread panic sell-off. While this can be rational in some instances, these reactions frequently cause investors to do the opposite of what good investing requires: instead of buying low and selling high, emotional investors can buy high and sell low. When emotions take over, rational decisions become quite rare.

Two specific psychological concepts, FOMO and loss aversion, also help explain why investors often make bad decisions. The fear of missing out, or FOMO, happens when investors see others making more money than they are and don’t want to be left out. This can lead to them buying stocks randomly just because the price is increasing, all while not considering if the investment has actual value. Social media has made this issue even more prevalent, since people can constantly see others that have had success. Loss aversion is a bit different than FOMO, as it happens when people feel the pain of losing money more intensely than the excitement when they gain money. Research shows that the emotional impact of a financial loss is around twice as strong as a financial gain for the average person. In terms of the stock market, this makes investors panic and sell at downturns, which leads to confirmed losses rather than the potential for prices to recover.

Confirmation Bias: Seeking Only What Confirms Beliefs

A digital drawing illustrating how confirmation bias works (via thedecisionlab.com).

Another psychological trap investors frequently fall into is confirmation bias, which is the tendency to look for information or evidence that supports what they already believe. This causes them to not research objectively; instead, they search for specific information that can be misleading. For example, if someone believes that a company will succeed, they may not consider warning signs like high levels of debt or declining sales. They’ll focus on just the positive information because it supports their existing beliefs about the company. This biased approach prevents investors from making fully informed decisions and increases the risk of holding onto a failing investment.

Short-Term Thinking in a Long-Term Game

Despite how volatile the stock market can appear, data measured over decades show consistent growth of the overall stock market. Broad market indexes such as the S&P 500 have averaged returns of around 7% per year. However, individual investors often fail to benefit from this growth because they focus too much on short-term price movements and don’t look at the bigger picture. Constantly checking stock prices creates anxiety, and as stated previously, this can lead to emotional decisions. Investors who panic on temporary downturns miss out on the recovery of the stock or index fund they have invested in. Historically, every major market crash, including the Great Recession and the COVID-19 market drop, has been followed by significant growth afterwards, with many recouping all of their losses and more! The investors who really succeeded weren’t the ones who acted quickly, but the ones who stayed patient with their investments.

Successful investing requires emotional discipline. One strategy that works for many people is to create a long-term plan, follow it strictly, and avoid reacting to every single change in the market. Another technique, called dollar-cost averaging, is investing the same amount of money at regular intervals regardless of market conditions. This removes the factor of emotion from decision-making and prevents the temptation to beat the market. Investors can greatly benefit from focusing less on daily fluctuations and more on the real financial performance of their portfolio. The market will always continue to have ups and downs, but buying for the long term will almost always favor growth.

Conclusion

To wrap up, the stock market is not driven by only numbers and logic. Human psychology, including emotions and tendencies, have a big impact on every market, let alone the stock market. At the core, emotional reactions driven by fear, greed, excitement, and panic are often responsible for many market movements. People who understand these factors have a smaller chance of making common mistakes in their investment decisions. The market rewards patience, discipline, and long-term thinking. This does not mean that trading in the short term doesn’t have good results. However, it has many more risks, and unless you are an experienced trader, it’s better to avoid short-term trading.