Being unable to sleep at night. Irritability and irrational behavior. These are all unfortunate consequences of overconcentration of risk. A lot of people will tell you that diversification is the key to success in the market. I disagree. Diversification is key to tolerating the pain. And tolerating the pain is key to emotional indifference and that is the KEY to winning market behavior.
The market is a constant psychological tug of rope between the group’s collective dynamic relationship between polar opposite emotions- Fear and Greed. The tension between these two feelings is the daily pulse of the market. Selling leads to more selling as crowd behavior takes hold. Everyone jumps in and on days of unanimous opinion, we observe capitulation. Everyone throws in the towel and that is usually the end of the downdraft, at least in the short-term. It’s often best seen with a big price reversal, where the market probes or makes new lows and then reverses this behavior during the day. The following day or days are often periods of rapid price appreciation.
The opposite of Fear is Greed. In this phenomenon, players can hardly control themselves. The frustration of losing out on the party is often greater than the pain of losing money. Stocks move higher inexplicably only to find more buyers desperately trying to get on board. There is a whole school of investing in part based on this phenomenon known as momentum investing.
It’s easy as a trader or investor to fall victim to both extremes. In fact I would venture to say that living in the extremes is the ordinary state of being and finding the equilibrium, the middle zone between fear and greed is the exception to human behavior, not the norm. That investor who can control his emotions and live in the calm middle zone will be far more successful than the average player living on the edges of fear or greed. The failure to understand behavioral pyschology applied to the market is often behind the passionate belief that you can’t time the market. If you can control your emotions, you will be way ahead of the game and may have a chance of timing the market.