Timing the Markets Using Crowd Psychology & Technical Analysis
Emotions drive the markets; everything else is noise
The majority of individuals enter the market with the false assumption that they can master what they need by reading several books, taking courses on investing or purchasing software that will do all the hard work for them. On all three counts, they are wrong, and the reason is simple; the underlying premise was wrong.
Neither fundamental Analysis nor technical analysis drives the markets; what drives the markets then? Emotions drive the markets, therefore if you understand the emotion driving the markets, you can identify the trend, and if you can identify the trend, the rest is all moot. If the trends positive (bullish), compile a list of strong stocks and use pullbacks to open new positions and vice versa.
Understanding the main driving force behind all Markets
As we are dealing with the markets, the focus is not on the individual but the crowd. Understanding the emotion that drives the crowd falls under the topic of Mass psychology. Mass Psychology, also known as crowd psychology or mob psychology, is a branch of social psychology. The most famous theorists in this field were Gustave Le Bon, Gabriel Tarde, and Sigmund Freud. Mass Psychology views the crowd as an entity; individuals lose themselves when they are in the crowd. It’s almost like seeing the Dr Jekyl/Hyde transformation in real life. Individuals in a crowd lose their inhibitions and feel free to do the things they would otherwise never imagine doing. For example, extreme acts of violence, or sexuality; they can take on undue amounts of risks, and this is seen in the markets.
It’s not what you know that helps you but what you think you know that hurts you
In no other place is this more applicable to the financial markets. Individuals assume their higher education can provide them with some edge and so they are destined to lose because they are using the wrong tools and working under the wrong premise.
A Buffet is a great place to learn about the markets
Buffets are famous for serving the worst kind of food, but they can pull this stunt off because they dress this food very nicely. Quantity trumps quality; the model works fabulously as the masses think they are getting a bargain, but instead, they are getting ripped off. But and there is always but, hidden in this orgy of food are some good dishes, but one needs to be patient and not let the urge to eat and taste everything takes over. If you take this route, you will notice that the chef is grilling choices piece of steak in the corner, or that there is small craving station that serving great slices of roast beef. The crowd, however, will focus on the Junk food that’s displayed prominently such as big slices of Pizza, Hamburgers, Hot Dogs, Tacos, chicken wings, chicken nuggets, pasta, etc
The Crowd at the Buffet is working under the wrong premise
The crowd assumes that more of everything is better; in essence, they are sacrificing quality for quantity. If you want to win in the markets, you need to stop being part of the herd. Focus on doing things that the herd deems as undesirable.
Using this analogy to the markets; where do the masses go for their financial advice? They head to places like CNBC, CNN, MSNBC, Market watch, the fool and host of other sites whose only purpose it seems is to serve you the wrong advice at precisely the right time. The result is always disastrous, and they have no one else to blame but themselves.
One of the most important lessons of Crowd Psychology is to invest when there is blood in the street and to sell when the crowd is ecstatic.
How do you put the above principle into play?
Contrarians will tell you that the best game plan is to take the position that’s opposite to that of the masses. However, there is a huge flaw with this line of thought, as the trend does not change the moment the masses join the party. The trend changes only when the crowd at the party is drunk, and they feel that things can and will only get better; it’s at that peak moment of joy that the trend suddenly changes direction. Therefore a person putting the basic principles of mass psychology to use would only act when the emotion that’s driving the market has peaked.
Once you understand the psychology behind the markets, you can start learning technical analysis. Before we move to the field of technical analysis, we need to cover a few principles that are essential for being on the right side of the markets
There is a time to buy, a time to sell and a time to do absolutely nothing. You should be able to identify such timelines with ease. Build a list of stock you would like to own over the long haul. You can use screener such as Finviz, to identify companies that match your criteria. Now examine the technical state of the company, is the stock trading in the extremely overbought ranges; if it is then waiting for it to let out some steam before jumping in. Before you put any money into the markets, make sure that the masses are not euphoric. As for the technical analysis part, we will cover it further in the article. Patience is a virtue that the astute investor uses to build a fortune.
Discipline is the ability to stick to a winning game plan without deviating; in other words, you might have to wait several months before a certain stock moves to the oversold ranges before opening a position. Don’t adjust your strategy to suit your needs; the market takes no prisoners and stupidity is always rewarded with a brutal beating.
Technical Analysis helps you fine-tune entry points once you have identified the trend
Find two to three technical oscillators that resonate with you, for example, RSI, MACD’s, Stochastic are just a few of the many indicators out there that you can use to determine if the markets are oversold or overbought.
Ideally, one should find two timelines that are in agreement; for example, the weekly and the daily charts should but indicate that the stock is oversold and vice versa. Once you open the position, you can direct your focus to the longer term weekly charts. One should take money off the table or close the position when the stock is trading in the extremely overbought ranges. However, if the masses are euphoric, then one should look to take off at least 50% of the table and implement tight stops.
Sadly the mass mindset is set on self-destruct mode; without knowing it, the average person gravitates faster towards a state of misery than to a state of calm. Hence, the saying misery loves company and stupidity demands it. How else can one explain that almost 90% of market participants lose money over the long run?
- Never buy when the crowd is euphoric and jump in when the crowd is panicking; this is the best time to find excellent long-term plays.
- Spend time identifying stocks you like; when opportunity knocks you will be ready to buy
- Paper trade first for in theory everything looks easier than it is. Once you feel that you have mastered things; start small. For example, the market might drop lower than you expected and the stock price might drop before it bottoms out.
- Focus on the trend for everything else is your foe