Markets, Psychology, and Irrationality
Where Worlds Collide
--
“The market can remain irrational longer than you can remain solvent.” — John Maynard Keynes
Some say markets are perfectly efficient, others say they are catastrophically irrational. The truth, however, lies somewhere in the middle, and has everything to do with psychology.
In the world of finance, I’d argue that the three most relevant psychological concepts are Behavioral Economics, market/social psychology, and trading psychology.
Behavioral Economics accounts for the unfortunate truth that we are not always rational actors. We don’t always weigh cost and benefits, future expected values, and make decisions today our future selves approve of.
I define market psychology as the behavior of groups due to reactionary emotions, such as fear and greed. Later on, we’ll look at examples of group movements playing out in the markets.
Finally, trading psychology is the study of how speculators can succeed in the markets when the world has set them up for failure. Our world teaches us lessons about money and interactions that are actively destructive to market participants.
“But why should I understand behavioral economics and the functions of markets? It’s all boring anyway,” you might say.
For the same reason every driver should have a fundamental understanding of how their car works, how to drive in different conditions, and how to manage grip. Life seems great when you’re driving on a sunny day’s highway, but when it’s pouring rain and you aquaplane, or it’s snowing and you lose the rear and oversteer, you berate yourself for not understanding the fundamentals of something with which you entrust your life.
The same goes for the markets. Markets are the undercurrent of the entire financial system. If you don’t understand how markets work, how can you be expected to invest for your future, avoid financial scams, and grow your net worth safely? When challenges arise amidst your financial journey, as they do on the roads, you want to be poised with the knowledge to overcome them as if they are nothing.
