Booms, busts and investor psychology – why investors need to be aware of the psychology of investing

August 17th 2022

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Key points

  • Investment markets are driven by more than just fundamentals. Investor psychology plays a huge role and helps explain why asset prices go through periodic booms and busts.
  • The key for investors is to be aware of the role of investor psychology and its influence on their own thinking. The best defence is to be aware of past market cycles (so nothing comes as a surprise) and to avoid being sucked into booms and spat out during busts. If an investor is looking to trade they should do so on a contrarian basis. This means accumulating when the crowd is panicking, lightening off when it is euphoric.



Up until the 1980s, the dominant theory was that financial markets were efficient – in other words, all relevant information was reflected in asset prices in a rational manner. While some think it was the Global Financial Crisis that caused faith in the so-called Efficient Markets Hypothesis (EMH) to begin unravelling, this actually occurred in the 1980s. In fact, it was the October 1987 crash that drove the nail in the coffin of the EMH as it was impossible to explain why US shares fell over 30% and Australian shares fell 50% in a two-month period when there was very little in the way of new information to justify such a move. It’s also hard to explain the 80% slump in the tech-heavy Nasdaq index between 2000 and 2002 on the basis of just fundamentals. Study after study has shown share market volatility is too high to be explained by investment fundamentals alone. Something else is at play, & that is investor psychology.


Investor psychology

Several aspects of investor psychology interact in helping drive bull and bear phases in investment markets, including individual lapses of logic and crowd psychology.


Individuals are not rational

Numerous studies by psychologists have shown that – apart from me and you! – people are not always rational and tend to suffer from various lapses of logic. The most significant examples are as follows.


The madness of crowds

As if individual irrationality is not enough, it tends to get magnified and reinforced by “crowd psychology”. Investment markets have long been considered as providing examples of crowd psychology at work. Collective behaviour in investment markets requires the presence of several things:


Bubbles and busts

The combination of lapses of logic by individuals in making investment decisions being magnified by crowd psychology go a long way to explaining why speculative surges in asset prices develop (usually after some good news) and how they feed on themselves (as individuals project recent price gains into the future, exercise “wishful thinking” & get positive feedback via the media, their friends, etc). Of course, the whole process goes into reverse once buying is exhausted, often triggered by contrary news to that which drove the rise initially.

Investor psychology through a market cycle looks like what Russell Investments called the roller coaster of investor emotion. When times are good, investors move from optimism to excitement, and eventually euphoria as an investment’s price – be it shares, housing, gold, cryptos or whatever – moves higher and higher. So by the time the market tops out investors as group are maximum bullish and fully invested, often with no one left to buy. This ultimately sets the scene for a bit of bad news to push prices lower. As selling intensifies and prices fall further, investor emotion goes from anxiety to desperation, and eventually capitulation and depression. By the time the market bottoms out investors are maximum bearish and many are out of the market. This then sets the scene for the market to bottom as it only requires a bit of good news (or less bad news) to bring back buying, and then the cycle repeats.


The roller coaster of investor emotion through a market cycle

inv psych 1
Source: Russell Investments, AMP


This pattern has been repeated time again over the years: in the early/mid-1990s with emerging markets; the late 1990s tech boom; the late 2000s with the focus on credit, and US housing; and arguably more recently with cryptocurrencies and yield plays.


Points to note

Firstly, confidence and investor psychology do not act in a vacuum. The move from depression at the bottom of a cycle to euphoria at the top is usually underpinned by fundamental developments, e.g., strong economic growth and easy money.

Second, at market extremes confidence is best read in a contrarian fashion – major bull markets do not start when investors are feeling euphoric and major bear markets do not start when they are depressed. By the time investor confidence has reached these extremes, all those who wish to buy (or sell) have done so meaning it only requires a small amount of bad news (or good news) to tip investors the other way. So extreme low points in confidence are often associated with market bottoms, and vice versa for extreme highs.

Third, ideally one needs to look at what investors are thinking (sentiment) and what they are actually doing (positioning).

Finally, negative crowd sentiment at market bottoms can tend to be associated fairly quickly with market bottoms reflecting the steep declines associated with panics as a market falls. But during bull markets positive sentiment or even euphoria can tend to persist for a while as it takes investors longer to build exposures to assets than to sell them.


So where are we now in relation to shares?

The next charts show the US share markets and a measure of US investor sentiment that includes surveys of investment newsletter writers and individual investors and the ratio of puts (options to sell shares) to calls (options to buy). It shows that extreme levels of pessimism tend to be associated with major market bottoms (indicated by the green arrows) and extreme measures of optimism tend to be associated with market tops (red arrows) although, as noted above, sentiment can be less reliable at tops.

Currently, the high levels of optimism seen last year are long gone after the plunge in shares, which left sentiment very negative and now sentiment is still negative but not extreme. If anything, this is mildly bullish from a contrarian perspective but after the rally since June it’s not a strong signal either way.


inv psych 2
Source: Bloomberg, Sentimentrader, Investors Intelligence, AMP


What does this mean for investors?

There are several implications for investors.


If you have any questions about this please get in touch with us.

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About the Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided. This document is not intended for distribution or use in any jurisdiction where it would be contrary to applicable laws, regulations or directives and does not constitute a recommendation, offer, solicitation or invitation to invest.