December 6, 2007

Understanding Stock Market Behaviour

[Prior Reading: The Concept of Groups]

The Stock Market is a perfect representation of group behaviour.

Millions of individuals (and Financial Institutions – run by individuals) participate in the buying and selling of stocks. Each individual takes a buy, sell or hold decision for each security based on his/her perception of the expected price movement. The actual price movement, in turn, depends on the sum total of the buy, sell, or hold decision taken by each individual. In a cyclic process the individual decisions are influenced by price movements, and the price movements are influenced by individual decisions.

Despite the Stock Market behaviour being a reflection of the consolidated individual behaviours, no individual or entity is able to consistently and correctly predict the price movement. People form perceptions on the price movement with all kind of analysis, but no one can be sure. There are heavy weight opinion leaders in the industry, e.g. large fund managers, historically successful investors, etc. They can influence the perception and behaviour of a large number of investors. Yet they are not able to predict or influence the actual price movement.

Sometimes positive sentiments create a self reinforcing cycle, often termed as the Bull Market. The prices of stocks keep on rising despite no major fundamental change. The Stock Market moves up. The investors feel that it would move up further, and hence they are willing to trade at higher prices. This in turn, further pushes up the stock market. The reverse is termed as the Bear Market, when the prices start falling without any fundamental change. This happens when the negative sentiments get triggered. The trigger may be something completely unrelated.

Despite all expertise, analysis and experience, the Stock Market behaves like an independent entity with a life of its own. Each and every individual influences the behaviour of the Stock Market, yet no single individual can understand, control or predict its behaviour.

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