One of the most important and probably most overlooked aspects of fundamental and technical analysis is behaviour. Behavioural finance is an area of financial study focused on how psychological influences affect market outcomes.
Market participants can use behavioural finance to understand different results across various sectors and industries.
Market Sentiment
A quick way to gauge market sentiment is to look at market surveys. One such survey used is the American Association of Individual Investors (AII), which measures the sentiment of individual investors. This is done weekly, along with other surveys that track the opinions of investment advisers.
The commitment of traders (CoT) report is also used to see the number of open positions in the futures market, known as open interest.
Seasonality
Seasonality is a characteristic of a time series in which the data experiences regular and predictable changes that recur every calendar year. Any predictable fluctuation or pattern that recurs or repeats over one year is said to be seasonal.
Seasonal effects differ from cyclical effects, as seasonal cycles are observed within one calendar year. In contrast, cyclical effects, such as boosted sales due to low unemployment rates, can span periods shorter or longer than one calendar year.
One of the critical aspects of behavioural finance studies is the influence of psychological biases. Let’s look at 3 of the most relevant ones:
Herd Behaviour
Herd behaviour states that people tend to mimic the financial behaviors of the majority of the herd. Herding/ herd mentality is notorious in the stock market as the cause behind dramatic rallies and sell-offs.
Self-Attribution
Self-attribution refers to a tendency to make choices based on overconfidence in one’s knowledge or skill.
Emotional Gap The emotional gap refers to decision-making based on extreme emotions or emotional strains such as anxiety, anger, fear, or excitement. Frequently, emotions are a crucial reason why people do not make rational choices.
