Investor Psychology
cease to rise. The stock price then starts downward, forming a top in the stock. As
prices fall, this influences more market participants to exit positions in the stock.
As more participants start exiting, this oversupply causes the price to fall even
further. And the process repeats, with prices now spiraling downward until all the
sellers have liquidated most of their shares in the stock, forming a new potential
bottom in the stock. Hence we have seen how positive feedback loops can cause
the markets to boom or bust. George Soros’s theory of reflexivity is based on posi-
tive feedback cycles.Contrarianism, herd behavior,
and the Under-Informed
The well‐informed or smart participants are usually contrarian only at tops and
bottoms. Being contrarian means buying when the under‐informed public is sell-
ing and selling when the under‐informed public is buying. They are not of a con-
trary opinion during a full‐blown trend phase. In fact, many contrarians are trend
followers during such a phase. It would spell financial suicide to adopt a contrary
position in a strong and prolonged trend. It is the large combined capital of the
under‐informed public, or herd, that is usually responsible for driving a trend up
or down. This, for example, allows the smart investors to accumulate shares at a
lower and more advantageous price preceding an uptrend and distribute shares at
a higher and more advantageous price preceding a downtrend.25.2 Behavioral Elements Associated with Chart Patterns
Price barriers and chart patterns exist because of behavioral phenomena. The
building blocks of any chart pattern lie in the way traders place trade orders in
the market. It is heuristic‐ or knowledge‐based bias in action. See Figure 25.1. It
is conventional to place buy orders above a barrier and sell orders below it. This
is because it is a learned behavior or attitude. This means that whenever price ap-
proaches a barrier, it will initially encounter an opposing force. For example, as
price descends toward a prior support level, it will initially encounter a concen-
tration of buy orders, driving price back up. In similar fashion, as price ascends
toward a prior resistance level, it will initially encounter a concentration of sell
orders, driving price back down. As such, all price barriers are trend inhibiting.
This learned behavior explains why triangles and channels exist. Every time
price tests the converging trendlines of a triangle or the parallel trendlines of a
price channel, it will initially rebound or pull back from these trendlines. It also
works fairly consistently because most traders react in the same manner to a
price barrier, which in itself further reinforces the belief that prices will react in
the expected manner. This is an example of the self‐fulfilling prophecy in action.
Figure 25.2 illustrates price reacting to the converging trendlines within a triangle
formation. This learned behavior or knowledge‐based attitude is also sometimes
referred to as magical thinking. Although there is a behavioral basis for price re-
acting in such a manner, the trader soon forgets the original reason and tends to