People’s collective opinion on what they think is the state of the market is the price. Our opinions are based on the fundamentals of the companies that make up the market. Markets behave rationally, until they don’t.
What do I mean by this?
Well, as humans we have common biases that go beyond the fundamentals of the market. During good times people start to get greedier and greedier. More and more confident. As markets continue to rise we all want a piece of those juicy returns. We start looking beyond the returns of companies and the fundamentals, and we start to buy just because we don’t want to miss out. When people act this way as a collective, the markets become less and less efficient. But we don’t care. During sustained periods of good times we become overconfident and forget that bad things can happen. Our tolerance for risk rises well above our original intentions. Greed takes over and more and more people try to get in on the action. Collectively this results in an overpriced market not based on fundamentals.
Conversely when markets start dropping people are not too concerned. It’s a natural part of investing. But then they go down 20%. 30%. Maybe even 40 or 50%. At some stage of the decline people start to become fearful. They worry companies are folding, the world is ending, and markets will never recover. This is when people start acting irrationally again. One person fearful is not a problem. But when thousands of people start making fear based decisions, the fear catches on. It is very difficult to protect yourself from this. Market fundamentals are out the window.
Extreme optimism and extreme despair make for very inefficient markets. This article isn’t about trying to time these highs and lows. It’s very difficult to tell the difference between market fundamentals and human overreactions. After all, the market is made up of human reactions. How to tell what is a collective over reaction ahead of time is extremely difficult. This is more of a reminder that we all have certain biases and blind spots such us over confidence and recency bias that we may not be aware of. These biases may force us to make rash decisions in the heat of the moment that could lose us a lot of money and sleep. Such as taking on too much risk during the good times, or not enough risk during the bad times. Just recognise these emotions, take a step back, and think if it is part of the plan or not.
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The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here