Wednesday, April 4, 2007

Market Psychology

This evening I was visiting with a friend of mine who is a commodities buyer for a very large feed company. He commented about how crazy the market was today. So, I asked him what he was talking about. He said, "corn futures jumped 16 cents on the news that it froze in Missouri. The crazy thing is, they haven't even planted corn in Missouri yet! What could it freeze out?"

The futures market is a very psychologically driven market. It has happened numerous times with cattle futures based on rumors of BSE or some other disease being found. It makes no logical sense to someone in the cattle business. It shows the influence of speculative traders that buy and sell based on psychological factors, not on reality.

The same thing happens in the stock market. Stocks that are totally unrelated to newsworthy events about a business, or industry, are often impacted as much or more than stocks that should directly be effected by a particular news item. It makes sense when the stock of a chip maker falls because its biggest customer is struggling with sales. It doesn't make sense when the entire lending industry is impacted adversely by news that a particular sub-prime lender is heading toward bankruptcy.

It is the individual who understands "mob" psychology that will often do well in the stock market -- at least in the short run. I personally believe that such market gyrations should be ignored and investment should be based on business value, sound management and a strong plan. Time should be taken to understand an industry and the factors that affect it before putting money into it. Gambling based on "gut feeling" is a sure way to lose. That "gut feeling" is often indigestion caused by worrying about an investment that had no real merit in the first place.

Futures markets are a tool for protecting the price of a commodity that one owns, or plans to own in the course of their business. When used properly, they can be a form of insurance against cash price moves based on real-world events. The stock market is a place to invest in well-managed companies that need additional capital to expand. It is a place that requires a long-term view for success. It isn't a place to ride the capricious price swings of a psychologically driven market in the hopes of a windfall. In that environment, only the professionals win.

The markets have always intrigued me. I guess it is part of the same thinking that caused me to major in Agricultural Economics in college. On the micro, or firm level, economics is just a way to evaluate decisions on how to best utilize the resources that you have at hand. On the macro, or system-wide level, economics is frequently heavily influenced by psychological factors. What drives consumer decision making? Are they always rational in their choices? Do businesses always make wise decisions? -- and on and on. The people side of it often creates the greatest uncertainty. Maybe that's why we hear so much about Consumer Confidence Levels and similar measures of people's attitudes about the economy.

I've always enjoyed watching people and puzzling over why they do the things they do. I don't think I'll ever figure it out though. If I did, I'd be wealthy from playing the games in the stock market.

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