Market psychology is the overarching sentiment of investors toward the stock market, and also their tendency as a group to pile-on in certain situations whether or not it is rational behavior and to exhibit other idiosyncrasies. Market psychology usually comes into conflict with the efficient market hypothesis tenet that investors are rational.
Behavioral finance and the study of market psychology has become a more relevant topic in the last 30 years or so since more main street investors are influencing prices in the market. If you have taken a psychology course, you will know that sometimes people behave in ways that are incongruent with what they believe or what is rational.
As a group, the psychology of investors can have dramatic effects on the prices and volatility of the market, and can even cause the market to crash, regardless of the fundamental soundness of the companies being traded.
Mass hysteria and panic are obviously characteristic of investors at certain points throughout history, and such behavior can be detrimental to the health of the market.
Circuit breaker policies on the stock exchanges that can halt trading when the market seems to be behaving in an unhealthy or disorganized manner are one measure used to curtail the potential effects of market psychology.
Academic research into this field is increasingly important as economists attempt to preserve the health of the marketplace and the economy, which can affect the standard of living of billions of people.
In an efficient market, prices are assumed to be the result of rational investors taking all information about risk and value into account, but if this is not the case much of the time, how much does it change the models?
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