Psychological decision making in the stock market

How should you think about stocks?

Author: Altay Shaw 
Editor: Ebani Dhawan
Artist: Patrick Marenda

The recent events that shook the stock market are still filling the headlines. GameStop, a Texas-based game retailer, was facing a ‘shorting’ by hedge fund managers. This is where a stock is undervalued so that individuals can profit in the short term rather than waiting to get longer-term dividend payouts or bonuses from a company. This attempt was thwarted by a subreddit group called r/wallstreetbets, that invested heavily and prevented the company from going into bankruptcy. Since the effort, proceeds of their work have gone to several charitable causes, including Gorilla Funds.  

Though the events have brought into question the legality of hedge fund business practices, it does raise an important psychological point. Finances are almost constantly on our minds, so it is important to consider how decision making and analysis are shaped by neural wiring and social influence.   

How does psychology apply to trading?

To understand the decisions made in trading, it is important to become acquainted with the term ‘trading psychology’. When trying to succeed in the world of trades and shares, people will typically be overcome with a sense of avariciousness, a greed for gaining wealth. Novices and professionals alike are vulnerable to feelings of catastrophic loss when a trade goes wrong. 

With this in mind, one may assume that the safest way to approach the stock market would be to take a calm and measured approach to trading. But, in most of the literature, the opposite is true. In studies that have been carried out into ‘behavioural finance’, there is an overwhelming consensus that individuals tend to play down their situation, claiming poor chance hampered them. This compromises their ability to judge risk, causing them to go beyond their limits, which is worsened when people put higher amounts into risky situations.  

What form of decision making works best for the stock market?

On the stock market, you can have two different positions. A short-term position is where you stand to make money on a short-term purchase of shares for up to a year, whereas in a long-term position, you hope to make larger profit ‒ provided that the buying power of the money invested either stays the same or increases above the rate of inflation

As a result, the decision-making process can be separated into two parts. There’s the split-second, in-the-moment decision to act fast to make a profit, which is wired within the cerebellum. The alternative is making a lengthy analysis of the past months of the stock and reading analysts reports about the future prospects of a company, which takes place in the frontal lobe

The process itself is more complex than simple localisation. In a 2017 study published in Neuron, neural activity was mapped by functional MRI when long-term decision-making occurred. In the test subjects, habituation to experiences allowed the animals to associate actions with positive or negative outcomes. This was able to demonstrate that in addition to the cerebellum’s well-established role in coordination and balance, it is also associated with control of emotions in reaching outcomes. 

How do group decisions and precedents affect future situations? 

Before the start of the year, many of us would not have considered ourselves to be financially literate. Maybe a parent or friend would mention a pension plan or their intent to invest but that would have been the extent of it. However, the political fallout following the decision of the trading app Robinhood to ban users from investing in GameStop, in order to protect hedge funds from losing large sums of money, has brought some questions to light. 

The episode of events has offered an interesting outlook on how reaching an outcome can be affected when a collective comes together. This falls under the principle that group decision-making should allow for a greater number of individuals to come together, considering different viewpoints and ideals in order to make the optimal choice for the group. These ideas were popularised in the late ‘70s, with Birt Duncan suggesting that a diverse group should be used to reach a decision, but a like-minded group is necessary to implement a change with minimal conflict. 

The effort made by r/wallstreetbets could be seen under this light. Social media-fuelled hype over the stocks was essential to ensuring people were made aware of the situation. Researchers at Oxford University showed that with correct targeting and discussion, individuals were more likely to heed the advice given by members of the Reddit group and invest in the GameStop shares. 

However, it is important to exercise caution in these matters. Whilst stocks can be a reasonable way to invest, getting sound advice is essential. r/wallstreetbets, though a group of like-minded individuals, is not accredited. Investments are volatile and though GameStop has worked for them, the saga of Hertz did not end so well despite efforts to increase the share price tenfold

In addition to this, groups that are mobilised to target specific stocks can cause high fluctuations in value. This can lead to volatility and forced control by companies, including Robinhood, to protect their own interests. 

Longer-term outcomes

We will have to wait for further updates in regards to the Robinhood case ‒ what rules and restrictions will be put in place as a result of the final verdict. Any measures that arise will have a lasting impact, if not in the form of radical change but, in the approach to trading and whether non-finance workers, individuals wanting to make ‘passive income’, will be able to take advantage and gain by playing a long game. 

The trading long game. 

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