How Does Investor Psychology Impact Trends?

As we know from basic economics, supply and demand establishes the price of any good. It is no different in the securities markets. Supply and demand, when sellers and buyers agree on a trade, determines prices. What does price, and especially price change, tell us? Presumably, if a substantial number of transactions occur at one price, the price is telling us that supply and demand are in a temporary equilibrium and that both buyers and sellers are satisfied. Of course, in the financial markets, long-term equilibrium is rarely reached. Prices constantly change, if only by miniscule amounts, as they move toward a theoretical equilibrium. They can oscillate in small increments or large; they can go up or down; or they can do both. Whatever the price movement, it is ultimately determined by the expectations and power of the buyers and sellers. If broad expectations are for a higher price in the future but with little or no capital to act, prices will remain as they are or even decline. Of course, expectations change, as does the power to act. Nothing is perfectly stable or constant in the markets.

When prices travel in a trend, called trending, they remain headed in one direction, and they tell us that there is an imbalance of demand and supply. Some will incorrectly say that there are more buyers than sellers or vice versa. However, in every transaction, there are an equal number of shares transacted, and, thus, there is always temporary equilibrium between buyers and sellers at that instant in time. What makes a trend is the power of the buyers or sellers—do they have enough stock or money?—and the aggressiveness or anxiousness of buyers and sellers—do they have specific information or deductions, rational or irrational, or are emotions of fear or greed propelling their action?

We know from behavioral studies that, psychologically, a positive feedback mechanism in our minds tends collectively to sustain a trend. In an uptrend, for example, buyers who have profited tend to continue being buyers, and new buyers, seeing what they have missed, also buy. The price trend continues upward. Eventually, over a longer period, prices revert to some kind of mean or value, but meanwhile, they trend up, down, or sideways. If, for example, prices are gradually rising, then buyers must have stronger positive expectations and be willing and able to place more money in the security. Contrarily, if prices are declining, sellers must have stronger negative expectations and larger positions to sell. The price trend, thus, tells us the amount of power, aggressiveness, and anxiousness there is in the marketplace to buy or sell each security. To the technical analyst, the basis for the expectations—and there are many—as well as the source of power, money, or stock, is largely irrelevant. The anticipating and “riding” a trend in prices, as long as it continues, is the way the technician profits.

Source: Kirkpatrick II Charles D., Dahlquist Julie R. (2015), Technical Analysis: The Complete Resource for Financial Market Technicians, FT Press; 3rd edition.

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