“Market is irrational.”
“Market is emotional.”
“Market drops way too far.”
“Market always works against me.”
Yes, the financial market that is supposed to be efficient and rational somehow does not seem to behave that way. Why? That is because the market participants are humans, and we are emotional creatures. However, as rational investors, we must set our emotions aside when dealing with the market. We must understand the psychology of a market cycle to learn how emotions drive market movements. This way, we can take advantage of this behavior.
The Psychology of a Market Cycle and Its Phases
We have seen this pattern. The market moves in waves up and down. Whether it’s the stock market, property market, gold price, or any market in general, they do not move in a straight line. They rise, peak, dip, and bottom out, and then the cycle repeats.
As an investor, we need to be aware of these market cycle phases to know what to expect next and potentially maximize our return. However, as much as we understand these phases, seasoned investors know that it is still hard to time the top and bottom of the market.
Let us take a look into these market cycle phases:
Accumulation Phase
This phase starts after the market has bottomed out. Smart money started buying and accumulating in this phase. The media generally portrays doomsday scenarios to the general public. Most retail investors exit the market, and on the other side of the trade is the smart money accumulating from them. Although the market is still bearish, the market sentiment starts to turn neutral soon, and the next phase begins.
Mark-up Phase
The market has stabilized in this phase. The media begins to portray that the worst may be over. Early investors and smart money continue to accumulate. Valuation starts to grow. As the phase matures, more retail investors feel the FOMO. Market sentiment is now bullish. As more late investors join in, the market enters a parabolic rise, reaching a climax, and valuation becomes stretched. The market is in euphoria. Smart money and insiders realize this and start to sell behind the scenes.
Distribution Phase
In this phase, the market sentiment changes from bullish to mixed. This phase is the period in which the market starts to change direction. The transition may last from a short to a relatively long period. The market is relatively stable, taking a breather before deciding on its next move. Some people think the market will still go up again. However, the valuation is usually already stretched to the upside. Greed still plays a role, and retail investors are still buying. Smart money has been selling its position. Soon, the market sentiment starts to change, and the next phase begins.
Mark-down Phase
This phase is the most painful phase of the cycle. Prices are free-falling. Those with existing positions are now at a significant loss. Some investors who try to buy the dip realize it keeps dipping. It is a falling knife tearing down everything in its way. Many investors are in denial, and panic starts creeping in. As the market keeps falling, retail investors give up, and retail capitulation ensues. Unfortunately, this is usually the sign that the bottom may be coming soon. This capitulation marks the end of the market cycle, and the new accumulation phase starts again.
What should we do?
Do not involve emotion in investing.
Investing should not involve emotion – leave that for your love life. Greed, FOMO, fear, and anxiety are emotional states you do not want to have when investing your hard-earned money. Emotion may cloud your judgment. Rational investors use a set of fundamental valuation methodologies to evaluate their investment opportunities. This way, you can avoid the FOMO feeling when the market approaches the top and valuation is getting stretched. At the same time, you will realize that significant opportunity starts to appear as the market is bottoming and the valuation is super low.
For sophisticated investors: Be fearful when others are greedy and be greedy when others are fearful.
The legendary investor Warren Buffet famous quote says: “Be fearful when others are greedy and be greedy when others are fearful.”
The market cycle shows the emotional state of the retail investors as the market goes up and down. Instead of being one of them, you can try to do the opposite. When everybody is greedy with the market in euphoria, it is time for you to be fearful. When the market turns, and everybody is fearful, it is your time to be greedy.
Keep in mind that this strategy involves timing the market. Therefore, we only recommend this strategy to the more sophisticated investors.
For average investors: Dollar Cost Averaging
If you want to avoid too much involvement with the market, stick with Dollar Cost Averaging (DCA) strategy. This strategy has historically been proven to outperform most professional investors.
To DCA means that you regularly invest in the market consistently (typically monthly or quarterly) regardless of the market, whether up or down. By always being in the market and buying through the ups and downs, you will come out with an average that beats most investors who try to time the market. People are terrible at timing the market. So this is why DCA is a powerful strategy that can give you a good return with minimal effort. Focus on the time in the market and not on timing the market.
