Making Sense of Stock Market Behavior

03/23/2010 12:01 am EST

Focus: STRATEGIES

When a person decides to enter the financial markets and learn to trade, they bring years of personal experiences with them. Those experiences are usually a detriment to profiting as they are based on one's life experiences. The financial markets, as well as all freely traded markets from stocks to commodities, from currencies to tulips, behave in a much different manner.

Typically, when we first learn how to trade, we study the markets and try to develop our own personal theories about how the markets work. Because we don't actually conduct formal experiments though, we fall prey to psychological biases.

Those same personal experiences, built over a lifetime, which helped us to advance and learn in our world, wind up being the very reason most traders fail to profit.

False Consensus Effect

One of these psychological biases is the false consensus effect. We tend to wrongly think that others believe what we believe and do what we will do, but that's only our perspective and it can mislead us.

Why is it difficult to anticipate what people will do? Part of the problem lies in the fact that we are mere mortals. Humans have a limited capacity for understanding complex information. In some ways, people can process information better than a computer, but in other ways, they cannot.

The false consensus effect is one of those rules of thumb that may bias our decisions. No matter what decision you ask people to make, no matter how important the issue, and no matter what choice is made, social psychologists have demonstrated that people overestimate the number of others who agree with them.

There is a natural tendency to believe that our decisions are relatively normal, appropriate, and similar to what our colleagues and peers would do in a similar situation.

We use our decisions as an "anchor" and evaluate what others would do based on what we would do. Decisions based on our own life experiences, and our own biases. Our interpretation of events and their consequences.

This decision-making bias can contribute to feelings of overconfidence. Once we make a decision, we tend to be confident that we are correct and that others will agree with us, but had we seen the situations from their perspective, we may see that they would behave quite differently.

Anticipating What the Masses Will Do

Market timing is often about anticipating what the masses will do. Will they buy or will they sell?

Take the past month for example. The stock market was down some 10% a month ago. There were many Elliott Wave analysts forecasting that this was the start of a decline that would test or go lower than the March 2009 declines.

The economic reports told us people were still losing jobs, that sentiment was still declining, and that the economic stimulus money was not helping.

But from those lows the markets have rallied. In fact, they have consistently rallied in the face of multiple concerns, any one of which could have derailed the advance.

All the way up and especially before new highs were achieved, many analysts still said the market was about to roll over. The end was near!

Yet the stock market continued to rise. It broke out to new highs and has now made multiple new highs. This is not what most expected.

It goes to show that you can't always anticipate precisely how people will react to world events. It's all a matter of having the right perspective, and it can be hard to find that perspective at times.

The Very Best Timing Strategies

The very best timing strategies follow market trends. They wait until the trend in confirmed and then climb on board, riding it as long as it lasts. If the trend fails, and some always do, they exit quickly and await the next trend.

This follows the old market saying, "Cut your losses short and let your winners run." Everyone has heard it, but so few are able to adhere to it.

That is why we follow trends here at Fibtimer.com. We do not try to forecast the future like other timers do (and usually fail at). We identify trends and take positions accordingly. If the trend fails, we exit quickly. If it continues, we ride it to the end. That could be weeks, or even months, as profits accumulate.

When the rally proved itself, we jumped back on board and have achieved solid profits over these past weeks.

Without following a specific strategy, you have chaos, and you will lose money.

Following a carefully defined strategy is the only sure way to be certain you will be in the right position at the right time, when the markets take off in one direction and stay in that direction.

Emotions should have no place in your decisions and they absolutely have no place in ours.

Unemotional buy and sell decisions generated by tried and true timing strategies are the most certain roads to profits.

By Frank Kollar of FibTimer.com

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