Investor sentiment can have a powerful influence over market movements. Recognizing what drives it is crucial for early recognition of bull markets and making successful investment decisions.
Investor sentiment analysis is one branch of behavioral finance research. Authors who work within it include both those from traditional economics as well as behavioral economics disciplines – as evidenced in Figure 1. An author co-citation density map depicting this is shown here (Fig 1).
Optimism
Investors typically feel optimistic in a bull market and are eager to purchase stocks, often due to factors like economic fundamentals or expectations that prices will increase.
Investors today are acutely aware of the risks posed by past financial catastrophes, like 2007 stock market crash. Their fear can lead them to adopt herd mentality by blindly following those around them and disregard their own research or instincts.
Studies have also demonstrated that optimists tend to quickly encode information related to positive outcomes while under-encoding any details associated with negative ones, leading them to overreact and receive less of what was anticipated – an effect known as optimism bias.
Greed
Greed is an overwhelming emotion that can drive seemingly rational people to make irresponsible financial decisions. It can be easy to get caught up in a bull market’s “get-rich-quick” mentality, investing in touted schemes or stocks promising big returns and investing with confidence in these seemingly quick ways to riches. Unfortunately, over-leveraging or overexposure may occur as well as overlooking important risk factors when making their decision making process.
As stock markets experience bull markets, demand exceeds supply for securities, driving up their prices. This can create herd behavior where investors follow what everyone else is doing as though everyone must know what’s best. Unfortunately, this often results in investors selling when markets experience large losses, as seen in this study which found dispositional greed to correlate positively with two measures of self-interest.
Fear of missing out
Few terms in investing are more evocative of opportunities and challenges alike than “bull market.” A bull market refers to periods when stock prices increase steadily. A bull market provides both great opportunity for investors while simultaneously creating unique challenges.
Investors who recognize early signs of a bull market can reap its benefits. Some indicators of such markets are positive market sentiment, stable price trends and rising corporate earnings.
Fear and greed can have a significant effect on investor behavior in a bull market. Fear of missing out can prompt many to invest without thoroughly researching their investments, creating herd mentality that leads to asset overvaluation as well as loss aversion which makes investors avoid losses more readily than gains.
Cognitive biases
Cognitive biases such as anchoring, confirmation bias and overconfidence can significantly distort investor decisions. Other heuristic biases like endowment effect, halo effect and status quo bias can add additional layers of irrationality into their calculations.
At the onset of a bull market, investors’ optimism fuels stock prices as it attracts newcomers who chase higher-performing stocks – further perpetuating its upward march. Unfortunately, herd mentalities can lead to asset overvaluation and price bubbles that burst when economic activity slows down – so investors need to understand the relationship between sentiment analysis and stock market performance for making more effective investment decisions.
Emotions
Fear and greed can lead investors to make emotional investment decisions that lack rational consideration. Herd behavior, which occurs frequently during bull markets, often sees investors following others instead of doing their own research – leading to unjustified exuberance that leads them into risky investments such as meme stocks without proper research being performed first.
Investor confidence is one of the cornerstones of bull market trends. Rising prices entice more investors to invest, leading to asset values increasing steadily over time. Unfortunately, this cycle can result in asset overvaluation, so understanding human psychology and cognitive biases are crucial in making sound investing choices during bull markets and to maximize return on investments. Keeping these factors in mind can help maximize returns on investments.
