Market psychology is an often underestimated tool, but essential for anyone pursuing some form of discretionary asset management strategies. Specifically, there a few areas of market psychology in which participants should be aware:
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the psychology of loss aversion
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how people interpret probabilities & risk
Anyone who has traded assets (or gambled) is likely familiar with the concept of loss aversion. People are more intrinsically impacted by losses than by gains. In other words, losses hurt more than gains feel good, even when the monetary value is the same. Loss aversion is the death of discretionary managers and traders, as their business is dealing with risk (and inevitable loss).
Generally speaking, people naturally overestimate the likelihood of low probability events occurring (perhaps buying PEPE at over $1.5Bn mkt cap expecting it to go up another 10x can be a lesson here). This is sometimes known as the possibility effect.
Similarly, we have the certainty effect which posits that events with a near certain occurrence are given lower weights than they should. We can sometimes see this dynamic in markets when a specific asset begins to trend. Often times participants will look for the laggards instead of buying into the asset that is already trending (to reduce risk as this asset’s number has already gone up… loss aversion). In reality, longing the leaders during these trending environments is almost always the prudent action.
