Any classically trained economist will claim that price is the equilibrium of supply and demand. When that fact remains to be true in Economics 101, in reality price is the collective consensus among market participants. Movement of price on the other hand reflects their combined expectation regarding the directional bias. However, in financial market we often see irrational price behavior. The irrationality derives from a mass psychological event which states often price movement is actually the result of its prior empirical movement.
- While individual investors typically like to think of themselves as making independent and objective decisions, they are often at the hidden whim of broader market psychology.
- Crowd behavior in markets has been known for centuries, with various asset bubbles like the famous Dutch Tulipmania attributed to the power of the masses.
- Herding behavior can spark large and unfounded market rallies and sell-offs that often lack fundamental support to justify the price action.
Individually, market participants can use intrinsic value by analyzing various economic or often technical indicators such as CPI, Inflation or MACD. Regardless, as a group, often Forex traders emphasize on their own herd mentality to buy or sell currencies which we call following the trend.
The trend following or herd mentality can be observed in irrational price movement such as spikes during news releases, working of support and resistance zones where majority of traders react to price action and turns those imaginary lines on their charts into self fulfilling prophecies. Even, often we see during a trend price respects ancient prime numbers, Fibonacci ratios and other fancy numbers. These technical tools sometimes work because the Mass Psychology of the Forex Market or the herd takes those numbers and tools seriously. For example, trend lines work because traders use trend lines! If enough traders end up using some kind of curve lines, those will also end up appearing to be working!
There is actually a cult in the financial market who became very successful by identifying how mass psychology works then blindly following the herd. Richard Driehaus popularized the idea that buying high, compared to buying low can be more profitable compared to the traditional investment paradigm which advocates buying low and selling high! Buying low and selling high is a concept best executed by world’s prominent investors like Warren Buffett. However, Mr. Driehaus became successful by simply following the mass psychology of the market and buying high and selling at even higher price, and revolutionized the theoretical concept of all short term investors, traders and speculators for the good.
Perhaps the finest testament to back this mass psychology based trading approach came from one of prominent British economist of the twentieth century, John Maynard Keynes, who said: “The market can stay irrational longer than you can stay solvent.”
What he meant by this famous quote was that trying to rationalize market or price and trading against the “trend” or herd mentality can ruin your account. However, if we can reverse our psychological conditioning, review and follow Mr. Richard Driehaus’s advice then contrary to worrying about our solvency, we can make a good amount of profit by simply following the irrational market.
There are a lot of technical trading techniques that follows this type of theoretical concept. For example, “breakouts” are one of the best strategies to follow crowd mentality of the market. When the price closes above or below an imaginary trading range, because key market participants observe this, they join in and push the price even higher once there is a breakout on the upside and vice-versa.
Using mass psychology to gain huge profit has its pitfalls as well. One of the key aspects of using herd mentality is learning to manage the inherent risk associated with using such strategy. Successful Forex traders understand that when irrational price movement can create trends, these phenomena can also change the trend and wipe their account very quickly, if the risk is not managed properly.
Understanding Herd Behavior
The key to such widespread phenomena lies in the herding nature of the crowd: the way in which a collection of usually calm, rational individuals can be overwhelmed by such emotion when it appears their peers are behaving in a certain universal manner. Those who study human behavior have repeatedly found that the fear of missing an opportunity for profits is a more enduring motivator than the fear of losing one’s life savings. At its fundamental level, this fear of being left out or failing when your friends, relatives, and neighbors seem to be making a killing, drives the overwhelming power of the crowd.
By nature, human beings also want to be part of a community of people with shared cultured and socioeconomic norms. Nevertheless, people still cherish their individuality and take responsibility for their own welfare. Investors can occasionally be induced into following the herd, whether through buying at the top of a market rally or jumping off the ship in a market sell-off. Behavioral finance attributes this conduct to the natural human tendency to be influenced by societal influences that trigger the fear of being alone or the fear of missing out.
Another motivating force behind crowd behavior is our tendency to look for leadership in the form of the balance of the crowd’s opinion (as we think that the majority must be right) or in the form of a few key individuals who seem to be driving the crowd’s behavior by virtue of their uncanny ability to predict the future. In times of uncertainty (and what is more uncertain than the multitude of choices facing us in the trading universe?), we look to strong leaders to guide our behavior and provide examples to follow. The seemingly omniscient market guru is but one example of the type of individual who purports to stand as an all-knowing leader of the crowd, but whose façade is the first to crumble when the tides of mania eventually turn.
What Do Mass Psychology and Herding Behavior Mean for Markets?
When people are overtaken by the power of greed or fear that becomes rampant in a market, overreactions can take place that distorts prices. On the side of greed, asset bubbles can inflate well beyond fundamentals. On the fear size, sell-offs can become protracted and depress prices well below where they should be.
Trade against the crowd
Many strategies have been built on market sentiment, and some of them are really based on work against public opinion. But this does not mean at all that the essence of such strategies is completely opposite actions to those of the crowd. On the contrary, trading is usually conducted in the direction as the crowd’s, but only up to a certain point. The main thing is to get off in time. In this case, the trader must adhere to a number of rules and each of the strategies defines them individually. It is important to realize that nothing, including the value of an asset, can constantly grow or, on the contrary, fall.
Despite the fact that there are several strategies based on the movement against the crowd, there are a number of rules that are taken into account in each of them.
When analyzing the tool, you should use charts of at least 1 hour. The optimal will be a 4-hour timeframe.
- It is recommended to refrain from trading in the accumulation phase.
- Short-term freezing of the asset price should be ignored altogether.
- Do not fix the price until the phase changes.
- It is not worth ignoring the setting of Take Profit, especially if there is no way to observe the market in real time.
The fight against greed, correctly conducted analysis and a clear plan – this is what will help get rid of the herd opinion and eventually subjugate the crowd. Not globally, of course, but psychologically certainly will let you get rid of the need for “public approval”.