Behavioral Factors in Financial Markets
How Psychology Moves Markets
Markets aren't just mathematical equations—they're driven by human decisions influenced by emotions, biases, and social dynamics.
Key Behavioral Factors:
- Sentiment: Collective optimism/pessimism
- Herding: Following the crowd
- Overreaction/Underreaction: Misprocessing information
- Feedback Loops: Price changes affecting behavior
Market Sentiment
Definition: Aggregate investor attitude toward market/asset.
Measurement:
- VIX ("fear index")
- Put/call ratios
- Survey indices (AAII sentiment, II sentiment)
- Fund flows (into/out of equities)
Impact: High optimism → Overvaluation → Crashes
Low pessimism → Undervaluation → Rallies
Indian Context: During 2021 bull run, Zerodha/Upstox account openings surged 400%+—extreme optimism signaling overheating.
Herding Behavior
Why It Occurs:
- Information cascade: "They know something I don't"
- Reputational concerns: "Better to fail conventionally"
- Social proof: "Everyone's buying, must be good"
Market Impact:
- Creates momentum (trends persist 6-12 months)
- Amplifies bubbles (everyone piles in)
- Deepens crashes (everyone exits together)
Examples:
- 2000 Dotcom: Herd into tech stocks → Bubble → Crash
- 2008 Housing: Herd into real estate → Bubble → Crisis
- 2021 Meme Stocks: Reddit herding → GameStop 2,700% spike
Overreaction & Underreaction
Underreaction (Conservatism Bias):
- Slow to incorporate new information
- Creates post-announcement drift (earnings surprises)
- Generates momentum (6-12 month continuation)
Overreaction:
- Extrapolate recent trends too far
- Creates mean reversion (3-5 year reversal)
- Value premium (overreacted-to bad news creates bargains)
Feedback Loops
Positive Feedback (Destabilizing):
- Price rises → Attracts buyers → Price rises more → More buyers
- Creates bubbles
Negative Feedback (Stabilizing):
- Price rises → Value investors sell (expensive) → Price stabilizes
- Prevents extreme overvaluation
Dominance Determines Stability: When positive feedback dominates (2000, 2008), bubbles form.
Noise Trading
Noise Traders: Trade on "noise" (rumors, tips) not information.
Impact:
- Create vol
atility (prices deviate from fundamentals)
- Generate trading volume
- Can push prices away from value short-term
Rational Response: Value investors wait patiently for correction.
Key Takeaways
- Sentiment: Aggregate emotions drive market swings
- Herding: Information cascades, reputation create crowd following
- Over/underreaction: Misprocessing creates momentum and reversal
- Feedback loops: Positive loops create bubbles, negative stabilize
- Noise trading: Non-fundamental trades add volatility
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