Tuesday, January 10, 2012

Risks due to Market Psychology

There are various risks which arise due to Market Psychology. The financial market attract lost of the brightest minds. Each day new techniques become a fad in the market. This is especially true for many technical indicators. Different technical indicators work differently in each market, This is due to the psychology of the traders operating in that market. Technical indicators usually study the market psychology in the form of charts. The market participants are known to show herd-behavior. It is well known that the emotions of Greed, Fear, Joy act on human beings and they act differently when subjected to these emotions. Hence, it can be understood that not everyone takes a rational decision based on available facts. Hence many times, the herd is usually wrong. This is a huge risk due to market psychology.

Most of the technical indicators give a buy signal when the trend for a stock is up for a long time. It is only due to the greed and the trend that a buyer will buy the stock. However, it may be quite different from the true market value of the stock based on fundamentals. Hence at times, buying a stock at a very high price may prove to be risky. The same is true otherwise. A distressed stock may not attract any investors and may not move up for a long time even though it is undervalued. Many technical indicators work on a self fulfilling prophecy basis. Hence many don't have a solid reasoning behind them. They might work well at times and attract many traders. Hence they seem to be working because everyone is using these techniques in their trading decisions. These are some of the risks arising due to market psychology. A field called behavioral finance studies the effect of behavior on the trading decisions people take.

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