Cycle of Market Emotions

Stock market runs in parallel and is generally ahead of the economic cycle – expansion, peak, contraction and trough. Equity market can be considered as the leading indicator to determine where the economy of the country is heading. This means that making investment in stock market on the basis of current status of economy is expecting what the market already did in past. It is crucial to understand that markets are front runners of the economy and they reflect the future prospect of the economy.

This minor difference in market cycle and economic cycle creates a dilemma for the investors and they get overrun by the extreme emotions; thus falling into the trap of buying highs and selling lows.

Investment based on such emotions is the only reason why majority of investors end up in buying at peaks and selling at lows or troughs thus losing their capital. This is because emotions govern the decision-making ability. Hence, when you feel greedy, you move into the market and become over optimistic and when you are fearful, you sell all your investments resulting to huge loss.

Below is the cycle of market emotions which can be experienced by majority of the investors.

Stage 1: Optimism, Excitement, Thrill and Euphoria:

This is the first phase of emotional cycle and it usually starts with optimism. All investors start to expect good returns for the risk they are bearing. When these expectations are met, they get excited about the possibility of even higher returns.

As market continues to go up, the excitement turns into the thrill and more investments are done due to greed. As this stage, everyone wants to jump in the market and suddenly the investors feels the euphoria. This is the point of maximum financial risk. 

Stage2: Anxiety, Denial, Fear and Desperation:

When the markets stop making new highs and meet expectations, it starts to turn around and shows the signs of weakness. This is the time when market moves in second phase of emotional cycle. Investors become more anxious and start to observe the market thinking about temporary correction.

Eventually, this anxiety turns into denial which suddenly turns into fear as market makes new lows and investment value starts declining. Uncertainty is at maximum at this stage. Further this fear turns into desperation and people start becoming defensive. At this time investors think of moving out of equity and invest in alternate options.

Stage 3: Panic, Capitulation and Despondency:

This is the third stage of cycle. When market plunges, people start experiencing the bear trend and there is panic all over the market. Most of the investors decide to surrender to the market and move out of the market by settling at losses.

Those who remain invested during this phase, become despondent and wonder if the market would ever recover. This is the time when investors feel bad about their investment decision in stock market and think that they will never invest in market again.

But at this stage, they fail to recognise that this is the point of maximum financial opportunity.

Stage 4: Depression, Hope, Relief and Optimism:

This is the final phase of emotional cycle. In the aftermath of the crash, market starts to rise gradually. Still investors are really cautious about the investments and think weather the market will reverse or continues its path. With the further rise of market, the situation becomes clear that the market is reversed and some hope emerges in the market.

Markets turn positive once again and there is a great sense of relief among the investors. More and more investors start investing and the second cycle starts over again with optimism.

Remember that most people enter into the market in the end during the peak of the market when stocks are expensive and end up selling at loss due to fear and loss of patience. Understanding the cycle of market emotions can help the investor to capitalise on such opportunities.

We should always remember the learning by Warren Buffet – “Be fearful when others are greedy and be greedy when others are fearful.”