Understanding The Investor Sentiment Cycle: Your Emotions Are Your Worst Enemy

Any historical chart of the Dow Jones Industrial Average demonstrates that the motion of the stock market is far from smooth. The gradual climb of the market over the past century comprises countless bull and bear markets' spikes and dips.

The emotional roller coaster that the typical trader endures throughout a market cycle is explained in something called the “investor sentiment cycle.” Understanding this cycle and interpreting its meaning may be the single most important part of stock trading.

A stock’s price is determined by how much investors believe it is worth. The psychology of investing in the market is the reason so many opportunities are created. Warren Buffett once famously said, “Be fearful when others are greedy and greedy when others are fearful.” The wisdom of this quote can be understood when looking at the investor sentiment cycle graphic:

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The idea behind the investor sentiment cycle is that human emotions are backward-looking. A typical shareholder experiences emotional reactions to changes that have already occurred. When a stock falls, traders get angry or scared. When it climbs, traders feel excited and confident. The problem is that these emotions often lead traders astray because they have no predictive value.

Controlling Emotions: The investor sentiment cycle represents a typical price cycle of a stock that is trading essentially flat over time. Notice that the stock price at the end of the cycle is the same as the stock price at the beginning. Looking at the cycle as a whole, an objective observer would see no need to have an emotional response to the cycle. The share price bounced around and then ended up where it started: no gain, no loss. However, human emotions occur in real time.

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A trader’s first reaction when a buy turns profitable will be a feeling of joy. It is natural to think, “This is easy! I am great at picking stocks!” The challenge at this point, the peak in the investor sentiment cycle, is to not make the mistake of buying more expensive shares. This period of the cycle comes with feelings of confidence and excitement because the rise in share price has provided positive reinforcement for the purchase. It is a fun experience, and it’s natural to want the fun to continue. However, this is the point in the cycle when Buffett would be selling.

A trader that continues to hold overpriced stocks for too long will inevitably endure a drop in share price and the worry that accompanies it. “It will go back up,” the trader might think, “This is just a bump in the road!” As it continues to drop, the trader will likely start feeling scared or overwhelmed and begin to think, “What is happening? How could I have lost all of this money?” This is the fearful lowest point in the investor sentiment cycle, and it's the point when Buffett gets greedy.

Benzinga's Take: There are two sides to the stock market: an analytical side and an emotional side. No matter how good a trader is at analyzing stocks, if emotions are allowed to dictate trading decisions, it will be difficult to make money in the long run.

One of the reasons so many people claim that the stock market is “rigged” or “unfair” is that normal human emotions tend to lead traders astray when it comes to stock trading. Once emotion is removed from trading, it is much easier to recognize the rare opportunities that occur when other traders are blinded by fear or greed.