Stock Buying Basics: Understanding the "Herd" Mentality
Although it can be very challenging for the average trader to analyze the glut of market signals on a daily basis, there is one condition that is easy to discern and quantify; the opinion of the masses. For example, when the majority of participants are in agreement on the current outlook, there is a high probability that a move in the opposite direction is forthcoming. Indeed, history suggests that stocks will rally once the majority of sellers have been accommodated. On the contrary, there is generally little potential for further upside activity when everyone who wants to buy is fully invested. This condition is typically more apparent during periods of high transaction volume and certainly lends credence to the phrase, "In the stock market, the public is right during the trends but wrong at both ends."
The Bullish-to-Bearish Cycle
The professionals (mostly scalpers and momentum traders) are first to exit, quietly closing out their positions while the public is overwhelmed by glowing earnings reports and bullish forecasts. As the stock struggles to hold its gains, daily volume drifts lower and the primary groups with long-term interests; the institutions and the general public, compete to determine the next trend. When the historical pattern exhibits the first signs of failure, the technicians begin to sell in earnest. Analysts often raise the company's targets to try to bolster the share value but once the issue no longer responds to 'good' news, the outcome is all too clear. Finally, the public becomes nervous and as the correction takes shape, closing orders multiply. Sadly, the fundamentalist is often the last to go, generally after a full-scale downtrend is in effect.
The Investor's Rationale
From a purely psychological viewpoint, it's obvious how human nature determines a person's actions in the stock market. Hope leads to fear, and then to acute financial anxiety, and the few desperate people that remain through it all (the true amateurs) eventually unload their positions for significant losses. In fact, you can almost feel the angst and hysteria of investors during the heart-pounding selling climax when it occurs in one conjunction with one of these bull-bear cycles.
After an issue has endured a substantial decline, it's tough to overcome the public's fear and loathing, as well as the prevailing disbelief that any recovery is forthcoming. The widespread panic propagated by dour doomsayers and the media's sensationalistic coverage of every negative event often creates an apparently insurmountable obstacle. The act of buying into weakness, in opposition of the crowd, will always feel uncomfortable and when the time comes to make the trade, it's unlikely the current news and research will be unbiased.