Why People Lose Money in Stocks: Cycle of Emotions in Trading
July 17, 2013
Here’s one interesting thing about stock market investing which I learned from my finance professors in school: The number of conversations about stock trading is directly proportional to the growth of the stock market.
What does that mean? You will notice that as stocks go through a phase of bullish periods and highs, more and more people start talking about stocks and stock investing.
We’ve seen this in the case of the Philippine stock market when its bullish run started 2-3 years ago.
The average person becomes a “stock market expert” — talking about how much he has made money in this or that stock. Several people — whose background, experience and expertise we do not know — emerge and market themselves as “stocks guru” offering investing and trading advise here and there.
You’ll know we are in this optimistic stage when news programs that usually focus on politics and entertainment (sometimes the same content in just one report) insert segments about stock markets and how the average person can make money in stocks.
‘Market Surge’ phase: Optimism
Welcome to the “Market Surge” phase of the Cycle of Emotions in Stock Trading.
In this phase, almost everyone is optimistic because all stock picks have been good picks, generating consistent returns month after month. It seems stock losses are a rare occurrence.
During “Market Surge”, stock prices continue to rise, and the average investor starts to believe he is an infallible stock investor. Indeed, almost all his picks have made him money — and to his surprise, even those stocks and companies he has not heard of have been producing enticing returns.
He then starts talking about stock investing to friends, family, practically everyone — bragging about a stock that has given him 20% in just a few weeks’ time and another that has earned him 100% in just a year’s time.
This sense of optimism becomes contagious and more people are enticed to join the stock market because “I don’t want to be left behind.” Those who do not even understand what stocks are and how the stock market works become instant investors and the next day start talking like stock market experts giving their own stocks analysis and trading advice.
‘Market Peak’ phase: Euphoria
Then comes the “Market Peak” stage. During this phase, stock prices reach unprecedented levels and stock markets achieve all-time highs.
Everyone’s enjoying the party and euphoria dominates the market. New and old stock investors alike are making a lot of money, and regardless of the stock they buy, it seems they have struck gold. Yes, including those stocks generally considered junk or speculative.
Investors are lulled by their unfailing stock pick prowess, and even those who just joined the market weeks or months ago buy stocks here and there as if they’re just buying new shoes or clothes. Hyped by stock market analysts proclaiming that new highs are coming, investors keep on buying stocks because “Everything’s going up and will still be up in the future.”
‘Market Decline’ phase: Fear
And then, prices start falling. A brand new set of analysts would emerge saying stock prices are inflated and that the stock market is overvalued.
Rationality starts to return in the markets, and those who realize they have paid a lot for a stock that is junk starts dumping these stocks. Investors who merely take cues from large institutional brokers follow suit, selling stocks here and there.
Retail investors, still reeling from the euphoric party in the previous stage, do not seem to understand what’s going on. Most of them cannot believe the party may be over. And yet they follow the herd and start unloading their portfolio too — sometimes even at a loss.
You’ll then notice that during this stage, the conversations about stock markets have started to decline. Gone are the day-to-day updates and stocks analysis of so-called stock gurus. News programs have moved back to reporting politics and entertainment. And your friend who has previously bragged about his huge earnings in this and that stock has suddenly gone quiet.
But the dark days are not yet over.
‘Market Bottom’ phase: Panic
The market continues its slide and reaches a bottom not seen by investors who recently joined the market. Prices have dropped to very low levels, creating panic especially among newbie investors who are now stuck with double-digit losses in stocks they just bought weeks ago.
Blogs, forums, and Facebook discussion groups, among others, are now dominated by posts of members asking “What do I do now?” And yet, most of the “experts” and “gurus” who paraded themselves during the Market Surge phase have disappeared or have gone quiet.
Newbie investors decide to take cues from movements in the stock market and seeing that “Sell! Sell! Sell!” seems to be the dominant mantra, are left to make a convenient — albeit painful — decision: that is, to sell at a huge loss.
This gloomy atmosphere drags on for years, and several investors realize stock market investing is not for them. They return to their normal lives, with a decision to permanently shun away from stock trading.
And we thought it’s over. But then, years later, the market picks up again, prices start rising and investors realize: the “Market Surge” phase is back.
The cycle has gone full circle and a new set of investors will join the cycle. In this next round, we just hope, stock investors would know how to be on top of the Cycle of Emotions in Trading.