The Psychology of Market Timing: Know When to Buy and Sell
Investing in the stock market could be seen as confusing especially when one is trying to determine the best time to invest. The pressure of the lists of possibilities of making profits or incurring losses can sometimes lead to making the wrong decisions. This is where the psychology of market timing comes in. Knowing the reasons that lead to certain decisions in our daily lives can help us become better and wiser decision makers. In this article, we will discuss the psychology of market timing and how to make sense of the investment process.
Fear of Missing Out (FOMO)
One of the most common psychological barriers for investors is the fear of missing out, or FOMO. This fear increases when we see other people making money and we are pressured to invest when the market is still good. FOMO can lead to buying signals, which in turn can lead to investors buying at overeated prices.
For example, in the late 1990s, there was the dot com bubble. Some investors, afraid of missing out, bought the shares of internet companies at euphoria prices. When the bubble burst, they lost a lot of money as the market went down.
To avoid FOMO it is important to stick to the long term plans rather than trying to get quick returns. Do not invest without a proper analysis and research and do not let yourself be influenced by the market mood or the fear of missing out on the profits.
Herd Behavior
Another factor that affects market timing is the herd effect. Since man is a social animal it is easier for him to follow the crowd in investment decisions. The embarrassment of being the only one or the fear of having a wrong strategy may make one follow others without even thinking for oneself.
In the mid 2000s there was a housing bubble where many people followed the herd and invested heavily in real estate. When the bubble burst many of them suffered a lot of losses.
To avoid the herd effect it is important to reason and make decisions on your investment based on your analysis and not that of others. It is important to be your own person and make the right decisions for you, even if it means going against the crowd, if it means you will be better off financially.
Confirmation Bias
Confirmation bias is another psychological effect that affects market timing. This is the situation where we tend to search for evidence that supports our initial positions and fail to seek evidence that goes against our positions. In investing, this bias can make us hold onto losing positions for longer than we should or ignore the warning signs that the position needs to be sold.
For example, you have invested in a particular company. Despite the fact that there is negative news and the company’s performance is declining, you remain positive about the company because you only watch the news that supports your decision.
In order to eliminate the confirmation bias effect, one must remain open minded and try to look at all the information available, the positive and the negative. Make sure to seek other people’s opinions and challenge your own to make more reasonable investment decisions.
Overconfidence
Overconfidence can also be the cause of our downfall in this case overconfidence can make us think that we know more than we actually do regarding market timing. This arrogance can lead to over trading, high risk taking and ultimately poor market returns.
A research conducted at the University of California established that over confident investors are likely to trade more frequently, incurring high transaction costs and thus getting lower returns than their less confident counterparts.
To avoid the effects of overconfidence it is important to remain realistic at all times. Learn to understand that it is very difficult to predict the market movements. Develop a investment plan that is based on sound principles and stick to it instead of trying to predict the market with your guts or overconfidence.
