As I get closer to my chartered designation, I find myself being more interested in behavioral finance (psychology). When investors hear the term technical analysis they often think of lines and patterns on a stock chart. I've even heard skeptics call it voodoo. Although, many are not aware that the driving force behind the lines and patterns is crowd psychology. A stock chart is nothing more than a picture of human emotions. The term 'price has memory' comes from the fact that support and resistance areas are created by human emotion and psychology. Not only is psychology important for understanding a stock chart, but it's very important for understanding our own manifestations and helps us to block out the unnecessary market noise. The hardest part is developing awareness. Once aware investors are able to mitigate the effects of their own biases while taking advantage of the herd behavior.

Today I'm going to focus on a few aspects of market psychology that every retail investor should know. But, first, we have to be able to distinguish between the two types of behavioral biases: cognitive and emotional. To simplify the classifications, a cognitive error can be defined as an information processing error (statistical and/or memory). It is often the result of faulty reasoning. Many times an investor will "think" they are using a rational process in their decision making but fail due to these errors. Once identified, cognitive errors can be easily fixed through better information and/or education. I'll give more examples throughout the blog, but one cognitive bias I see every day in the financial world is called anchoring bias or the anchoring effect. Anchoring bias can be defined as "relying too heavily on an initial piece of information offered when making decisions". With this bias investors will often place too much weight on a magic threshold. As an example, the 200-day moving average. Many investors will not buy a stock unless it's above the 200-day moving average. Thus, identifying it as some kind of a magical resistance line rather than performing the appropriate calculations based on actual price action. The media also loves hyping up these magical thresholds. For example, if the S&P 500 continues to climb back toward the all-time high, I can guarantee the phase "S&P 500 - $3000" will be repeated until our ears bleed.

Conversely, emotional biases are much harder to correct because they stem from impulse and/or intuition. Often an investor needs to first recognize these issues, then find a way to minimize the effects. 

Two different cognitive errors demonstrated above are conservatism bias and cognitive dissonance bias. The conservatism bias is the tendency to give too little weight to new information (the short report), therefore people fail to modify their prior beliefs as much as the new information would warrant. Cognitive dissonance bias occurs when newly acquired information conflicts with preexisting understandings. People will go to great lengths to defend their view despite new information (It happens in the uranium and gold sectors as well).

Below I go over the behavioral elements associated with market trends and the psychological forces that drive them.  The following ideas were learned from, The Handbook of Technical Analysis + Test Bank: The Practitioner's Comprehensive Guide to Technical Analysis by Mark Andrew Lim. The book is a must-read for anyone interested in technical analysis.