We used to think that to become a successful financier one should have a good understanding of the global economy, know and identify its cycles, understand the financial markets, and skillfully use all existing tools for investment management and earning a good income. And so it would be if the process was conducted by computers, but as we all know it is driven by us, humans.
"What actually registers in the stock market’s fluctuations are not the events themselves, but the human reactions to these events. In short, how millions of individual men and women feel these happenings may affect their future. Above all else, in other words, the stock market is people. It is people trying to read the future," the famous American financier and adviser to many American presidents, Bernard Baruch said as early as in beginning of the last century.
Prices of financial instruments are in constant motion, and although they tend to blend in with the value of underlying assets, sometimes, for some time, such harmony disappears, for certain reasons, resulting in value fluctuations. These reasons are hidden in human psychology which inevitably leaves a mark on the stock market.
The first attempt to apply psychology to economics was undertaken by the French sociologist, criminologist and social psychologist Gabriel Tarde, who conceived sociology as based on small psychological interactions among individuals. He used this concept in 1881, and in 1902 wrote a book on the subject "La Psychologie Economique." Gustave Le Bon (French social psychologist and politician (1841-1931) in 1885 described the elements of the concept in his classic book "La Psychologie Des Foules" ("The Crowd: A Study of the Popular Mind"), published in 1897. Tarde and Le Bon were followed by Maurice Clark, who published his "Economics and Modern Psychology" in 1918.
"The economist may attempt to ignore psychology, but it is sheer impossibility for him to ignore human nature," he wrote. "If the economist borrows his conception of man from the psychologist, his constructive work may have some chance of remaining purely economic in character. But if he does not, he will not thereby avoid psychology. Rather, he will force himself to make his own, and it will be bad psychology."
Later, psychology becomes an important element in the theories of Austrian economists Friedrich von Hayek, Ludwig von Mises and a Hungarian-born American psychologist George Katona. The latter presented it to American economic community in the 40-ies of XX century and as a result considerably acquired its confidence. Katona used well documented, empirical data collected from real life as a basis for his theories. He was the first psychologist, focusing his attention on psychological problems at the macroeconomic level.
The study of this trend is gaining more and more strength and today is often called behavioral finance and over time is being increasingly used on professional level by many banks and financial institutions. They set up special units which closely collaborate with the various investment departments of these institutions to develop a common strategy to be used in customer services as well as in determining the lenders’ own positions and personnel training sensitizing the stuff to clients' thinking errors and cognitive distortions.
Psychology of human behavior is the key to understanding what is happening on financial markets. All the usual, everyday feelings and desires manifest themselves in harsh market battles. Inherent to all of us feelings of fear, greed, hope, etc. have sometimes decisive influence on the trader’s behavior in a fast pace of stock trading. Weak and arrogant, greedy and slow, all these people are doomed to become victims of the market. At the same time, knowledge of their own abilities and preferences, both positive and negative qualities can help to avoid bankruptcy. One will have a guaranteed success if adds to all aforementioned the ability to adequately assess the psychological state and behavior of the market crowd.
Often it is the financial advisor who should stand at a second line of defense, be a sort of a buffer protecting the client from himself. It is the advisor who must be open and sensitive to the client’s behavior and fully aware of his current motivations. Investor’s success lies not only in his experience and knowledge of economic and financial markets, but namely in knowledge of human nature, in self-actualisation. Investor should always be in control of his senses fully realising what drives him to this or that decision and action no matter if it opens or closes position or just affords him to cool off.
Besides economic and financial knowledge investor’s success lies mainly in two other spheres enabling him to self-actualise and rise above his own nature and keep emotions in check and, what is more important, to anticipate the reaction of others on the course of events. This means that in addition to abilities to forecast the course of economic development, one needs to predict the reaction of the main stock market players on the course of economic development.
I have often advised in my articles and to my clients to invest in gold, including times in the midst of crisis when gold itself began falling in price. Let's examine the cause of such an advice. As an economist, I could foresee the chain reaction of the dawning crisis. I could not know if the price at the times of a crisis was the right price for the product, but what I could do is to foresee human response to the expected events. Advising to buy gold I relied on common human fear that makes us look for a safe place when confronting danger. This safe place is gold, as more players turn to precious metals as an escape when economic indicators do not offer any prospects of a light at the end of the tunnel. Why gold? Because in the past it was gold that always enabled people to keep their wealth regardless of its quantity. I relied on the human senses and human knowledge of the past. One of the customary investor’s behavior is to analise the past trying to predict the future.
Fluctuations in gold prices on the one hand drive to inflation and on the other hand indicate the levels of pessimism or optimism regarding economic development that is human reaction to what is happening. I still continue to advise buying gold for the same reason. There is another reason why you should continue to buy into gold, it is because the investor has no opportunity cost. If money just lies dormant on bank accounts it does not only fail to earn more money but loses purchasing power as well as faces an increased risk of hyperinflation. Until the time when economy starts to give signals to the world it became to edge out of the global crisis, people's behavior will push the gold market up. Increasing refinancing would indicate a change of this behavior.
Greed is the driving force that makes us operate on speculative financial markets.
If the greed is not oversized, then a player will carry few transactions, thus missing many opportunities. In such a case I recommend to engage in another type of business, which is more secure.
But if your greed is boundless, then you will try to carry as many deals as possible, putting yourself at a risk of uncertain prospects. So my advice to such investors is to gamble, as it will be more natural to their character and the losses are not to be so high.
Greed results in transactions conclusion motivation, which is split into two categories of rational and irrational. Professional investor uses a rational motivation and irrational motivation is inherent to a gambler, although it exists in every investor. Investors only difference is the ability to control their excitement. Those investors who are slaves to their emotions are doomed to lose.
The best cure for greed and excitement is to create a financial action plan.
Investor must be passionless in his decision on stock positions as a surgeon at work, where there is no place for emotions. Thinking over and approving the action plan with due account for various course of events is of utmost importance before entering a position. At this moment investor must be absolutely passionless and not prevailed by his emotions of greed or fear.
Independent professional is indispensible to private investor in protecting him against himself and as a result saving him from large losses due to human emotions. Such assistance will help private investor to avoid big losses and rely on the experience of his psychological counselor. And you should not think that the adviser is smarter, it is just not possible to understand your emotional reactions not going all the way on the path of investment, not filling and emptying the bowl of your emotions.
Established professional will be able to properly assess the situation and try to restrain the client from reckless actions to save him from unnecessary losses due to nothing but an error in simple human emotions.
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