Editor’s Note:
While it’s important to know which stocks to trade, the truth is… learning how emotions affect the market can be an even more valuable skill.
In today’s guest article, The Oxford Club’s Chief Income Strategist Marc Lichtenfeld explains how understanding panic and euphoria can turn you into a high-level trader.
– Ryan Fitzwater, Publisher
I’ve learned a lot of lessons about investing in my life. Many were learned the hard way – by losing money in the market − but some came from books and the classroom.
Behavioral finance was my favorite and most useful class.
Sure, understanding a financial statement is worthwhile. But the most important thing I’ve learned is that stocks trade based on two things: fear and greed.
A stock doesn’t jump because a company earned $1.10 per share. It rises because investors believe the current price is too low if the company earned $1.10 per share. They expect the stock price to go up, so they buy shares.
However, suppose a different company earned the same amount of profit, but that number leads to fear that the business is deteriorating. Investors sell, and the stock declines.
Same $1.10 per share in earnings, different emotions surrounding that result.
Fear… and greed.
When emotions get to extreme levels, it’s often a good time to buy or sell, depending on whether the emotion is fear or greed.
There are various indicators to help traders determine when sentiment is at heightened levels. Good traders can effectively trade these swings, but it’s not easy. Fear and greed can sometimes move in unforeseen ways. Sentiment may stay extreme for longer than expected, or it may instantly reverse.
One of the most important things to understand in the market is that when sentiment is euphoric – when folks believe the market can only go up, professionals like doctors and lawyers are quitting their jobs to start trading, and Uber drivers are giving stock picks – that is often a time to get fearful and do some selling.
The same is true when fear is overwhelming the market. Think back to the global financial crisis − or, more recently, the COVID crash in 2020. Investors and the population in general assumed things were going to be bad for a long, long time. In the case of the global financial crisis, some believed it was the end of the economy as we know it.
While the crisis was very real, the economy, of course, recovered like it always has. Had you bought stocks while everyone else was selling, it would have provided an amazing entry point.
(And remember, the market bottomed in March 2009, well before the economists and market pundits gave the all-clear signal.)
The lesson here is not to wait for things to change, but to take action when it feels like things will never change. The action you take should be the opposite of what you’re feeling.
When investors become excessively fearful or greedy, that is usually an excellent time to enter or exit your positions. Markets don’t stay sky-high or in the basement forever. There’s an ebb and flow. Train yourself to go against the grain at extremes. When you learn how to do that, your trading and investing will improve dramatically.
Good investing,
Marc
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