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Market and Mindset
The market is prone to extreme mood swings that cause prices to fluctuate wildly, often disconnected from fundamental value. These mood swings tend to oscillate between euphoria and depression, leading to overpricing and underpricing of assets.
The key is to remain rational when others are being irrational and to see market overreactions as opportunities rather than threats.
Irrational Behaviour
Several factors contribute to irrational market behaviour:
- Perception shifts: Investors' perceptions of events can change dramatically, even when actual conditions haven't changed much.
- Cognitive dissonance: Investors tend to ignore or reject information that contradicts their existing beliefs.
- Contagion: Negative sentiment in one market can spread rapidly to others, like a game of telephone.
- Ambiguous interpretation: The same news can be interpreted positively or negatively depending on the prevailing mood.
Psychological Factors
- Optimism bias: Investors, especially equity investors, tend to be optimistic by nature.
- Wishful thinking: People often believe what they want to be true, rather than what is actually true.
- Short memory: Investors quickly forget past mistakes, leading to repeated cycles of euphoria and panic.
Lack of Immutable Rules
Unlike natural sciences, investing lacks consistent, immutable rules. What works in one market environment may not work in another. This lack of dependable principles contributes to market instability.
Voting Machine
The market acts more like a voting machine reflecting investor sentiment rather than a weighing machine assessing fundamental value. Daily price movements often reflect changes in psychology rather than changes in underlying fundamentals.
Opportunity in Volatility
Prudent investors can take advantage of volatility by:
- Forming independent views on asset values based on fundamental analysis
- Selling when prices are irrationally high
- Buying when prices are irrationally low