Hello Tigers!
In our previous lesson, we explored cognitive biases and how they lead us to repeat mistakes in investing. Today, we’ll move one step further into another powerful psychological factor that shapes market behavior: stock market sentiment.
Why Market Sentiment Influences Investment Decisions?
Traditional finance theory holds that stock prices always reflect the underlying value of listed companies. But is this really the case?
Investors who have put their money into stocks should be aware that in actual financial markets, stock prices frequently diverge significantly from the true value of the listed companies. This phenomenon is primarily driven by investor sentiment.
Emotions play a dominant role in shaping many aspects of our lives. They influence our decisions, the conclusions we draw from past experiences, and even our personalities. In fact, in many ways, what we perceive as reality is shaped more by feelings than by facts. Psychologists estimate that emotions account for roughly 80% of our choices, leaving only 20% to objective reasoning and factual analysis.
On Wall Street, there is an old saying: “Financial markets are driven by two powerful emotions — greed and fear.” Legendary investor Warren Buffett echoed this idea, writing to shareholders: “Fear and greed, these two highly contagious diseases, occasionally erupt but will always exist in the investment market.”
In practice, stock market sentiment behaves like a pendulum. It swings from irrational exuberance to baseless pessimism, creating cycles that often lead investors to make the wrong decisions at the wrong times. These emotional cycles can manifest in clear patterns, such as overbuying and overselling.
For instance, when investing sentiment turns pessimistic, investors may panic and oversell their holdings, pushing stock prices below their true value. On the other hand, when sentiment is overly optimistic, investors may overbuy, driving prices above reasonable valuations.
This emotion-driven behavior deviates from rational investment, causing market prices to deviate from their true value.
Three Types of Stock Market Sentiment
In investment, emotional swings frequently cause stock prices to deviate from their true value and lead investors to make detrimental decisions. Below are the three most common types of negative sentiment that impact investment returns:
Type 1: Overconfidence
Confidence is the recognition of one’s abilities, but when that confidence exceeds reality, it becomes overconfidence. Traditional finance assumes that rational investors accurately assess their skills, while in practice, most overestimate their knowledge and control over outcomes.
This overconfidence often leads investors to ignore risks and trade excessively.
In other words, when they shouldn't buy, many keep buying continuously; when they shouldn't sell, many keep selling continuously. Many investors make numerous trades but find they haven't made much money.
The more they trade, the more they lose, and this is the reason.
Type 2: Emotional Bias
Emotional bias arises when decisions are guided by feelings rather than facts.
In 2018, a survey by a large brokerage firm found that when the S&P 500 index fell by 4.38%, the losses of ordinary investors were often more than double this figure. The reason is that during market downturns, many investors make judgments based on emotions, resulting in more losses.
Two emotions dominate this type of sentiment: greed and fear.
Greed pushes investors to chase high-risk opportunities without fully understanding the underlying risks. Many enter the market hastily, lured by potential returns, only to suffer when volatility strikes. Examples include speculative trading or frequent market timing in pursuit of quick profits — behaviors that often backfire.
Fear, on the other hand, drives investors to avoid losses at any cost. When markets fall or unexpected “black swan” events occur, they rush to sell, even if that means locking in losses and missing future rebounds. Over the long term, this risk-averse behavior reduces overall returns and prevents wealth accumulation.
Type 3: Attention Deficit
Modern investors are constantly bombarded with information. However, not all information is meaningful, and the human brain often struggles to separate signal from noise. Psychologists call this attention bias — our tendency to confuse the seriousness of an event with its likelihood.
For instance, when media heavily reports airplane crashes, people fear flying, even though it’s statistically safer than driving. Similarly, in finance, investors may overreact to dramatic headlines while overlooking gradual but significant risks.
Making decisions based on short-term news, social media trends, or personal opinions can lead to overreactions and poor timing.
Good investors try to avoid reacting to short-term events and instead of seizing market opportunities by predicting (or responding to) short-term events.
Alternatively, you can lengthen your time frame, using time to "smooth out" the fluctuations generated by short-term events, thereby minimizing the likelihood of making erroneous investment decisions due to attention deficit.
Conclusion
As Warren Buffett once said, "In investing, it's not necessary to do extraordinary things to achieve extraordinary results." Success in the market isn’t about chasing complex strategies, it’s about staying calm and making clear-headed decisions, even when emotions run high.
Knowing how stock market sentiment affects trading can help you resist impulsive moves and avoid common mistakes driven by overconfidence, greed, fear, or short-term market noise.
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