Loss Aversion and Stock Market Trading Explained

Alex Stal
  • October 8th 2019, 07:22

Speculation and Emotion Oftentimes Trump Common Sense in Stock Market Trading!

Making the right investment decision in the stock market is difficult at the best of times. We are taught from the get-go that if the fundamentals of a stock are sound, and there is upward growth potential, then that stock is for all intents and purposes a safe investment. However, stock market price movements are driven more by emotion and speculation than by fundamentals. The NASDAQ index has been enjoying a bull run of late, and the vast majority of tech stocks have shattered records in recent times. Of course the cyclical nature of stock price movements always comes into play and the market is now trading below those record levels.

Several years ago the S&P 500 Index and the Dow Jones Industrial Average both enjoyed similar realities. For the most part, investors tend to react to information spread through financial media – regardless of whether it is based on fact or not. Reports are continuously circulating about certain stocks being undervalued, perhaps even overvalued, and these assessments lead to the concomitant purchases and sales of stocks. The market is in a constant state of flux with buyers and sellers going at it like a pack of wolves tearing at a piece of meat.

Positive & Negative Sentiment in Stocks Trading

When negative sentiment pervades stock market an interesting set of factors comes into play. Consider that in today’s investment arena, most everything is automated. This is important for several reasons: When negative sentiment is mass circulated about a particular stock, that triggers a frenzy of selling in the markets. As stocks become oversold, so their price rapidly drops. Investment entities and fund managers that have those particular stocks as part of their investment portfolios will also have trigger points worked into the equation.

Simply put, if the stock price falls below a certain level there will be mass automated sales orders – stop loss orders – executed by these automatic trading mechanisms. This perpetuates the downward spiral in prices, while it also serves to act as a trigger for purchase orders of the same stock. Investors tend to make purchases when prices are dropping and to initiate stop loss orders when prices fall below a certain floor level. This constant interaction between buyers and sellers is what drives the market mechanism with stocks, and very little of it is based on fundamentals. It is known as the price-setting mechanism.

This leads to several possible realities: If investors perceive a stock to be undervalued, they will purchase it until it achieves its ‘fair’ market price. If by contrast investors perceive a stock to be overvalued, they will sell the stock until it reaches its ‘fair’ market price. Of course, these price points are never carved in stone, always changing and subject to myriad factors. This is a big part of the reason why many lay people consider the stock market to be akin to a crapshoot. Without an in-depth understanding of market fundamentals and the range of factors that impact on stock prices, you are essentially shooting craps blindfolded.

Psychology and Investment Trends

Fear and greed are two innate human characteristics that are responsible for most of haphazard investments that take place on a daily basis on the world forces. Our fear of losing money has been reported to be twice as strong as our desire to make money. When we are faced with the prospect of losing a substantial sum of money, we tend to make costly decisions to avoid that predicament from coming to pass. This manifests in many investors selling sound investments for fear that they may lose all their money. When mass panic sets in, this trend becomes a tsunami in the market and results in devastating losses for all. The fact of the matter is that markets can just as easily bullish as they can turn bearish.

Investment analysts from Banc De Binary continually stress the need to stay invested at all times. There is nothing to be gained by sitting on the sidelines with cash in hand. Stock market gains can only be realised by re-investing games and divesting from certain investments that have hit their peak and are now on a downhill slide, and reinvesting those proceeds into up-and-coming stocks which will show further growth down the line. The important point here is to stay in market. This process of selling winners and investing in purported losers is what is known as rebalancing your financial portfolio.

The act of rebalancing tends to go against human nature. What you are in fact required to do is sell a strongly performing stock and reinvest those proceeds in a stock that has yet to prove itself. Of course this is not a slapdash action with no insight into the stocks you are selling and the stocks you are buying. All the usual due diligence is required to forecast which stock options have upside potential. Even if the market is trending negative, there are ways to stay invested while minimizing your overall risk. Many investments are ideally suited to bearish markets, including put options, securities of deposit, gold stocks and the like.

For bullish markets, it is imperative to have excess capital on hand to pour into fast-growing stocks. A balanced approach to stock market investing takes the form of hedge funds which invest in multiple stocks, bonds, and other asset allocations to provide you with moderate growth and moderate levels of risk. Balanced portfolios are the best investments for overall growth and peace of mind. The returns will be more consistent and the overall volatility will be greatly diminished. 

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