The Anatomy of a Market Trend

In the short run, markets do not behave according to fundamentals. In fact, the short term movements are often whimsical and have no basis in reality. These movements are often called market trends. They tend to perpetuate themselves.

For instance, if a short term movement causes the market to move downwards, then this trend tends to continue. The downward movements become more pronounced and accentuated. In this article, we will have a closer look at market trends, what causes them and how the lead to transfer of wealth.

Market Trends and Transfer of Wealth

Market trends trigger emotional responses from investors. These emotional responses are what lead the investors to make irrational buy and sell decisions. Hence, market trends are responsible for transfer of wealth between investor classes.

It has been observed that retail investors perform the worst when it comes to negotiating market trends. The retail class does the exact opposite of what should be done. They buy when trends are forcing the prices higher and sell when trends are forcing the prices lower.

Therefore, they are inevitably the ones that are left to bear the losses. It is for this reason that some experts suggest that the correct way to invest is to do the exact opposite of what a retail investor is doing in the marketplace.

The Trigger Event

Market trends tend to begin with a trigger event. This event is a major occurring that everyone in the market notices. For instance, this may be the introduction of a new tax or the coming of poor economic data from a country like the United States.

Each of these events signals that the business environment will be distressed in the near future. Hence, this event is likely to cause an emotional reaction. Panic struck retail investors will queue up to sell their investments.

The Bulls and Bears Fight

Markets are made up of opposing forces. Hence if the introduction of a new tax is dragging the stock prices down, there will always be a group of investors that will believe that the market has fallen enough and will try to create an opposing rally.

The result is that a fight ensues between the bulls and the bears. Although anyone could win this fight and drive the trend, usually the original trend prevails. This is because it also has retail investors backing it up.

In simpler words when the market tends to go downwards on the back of a trend, it keeps on going downwards because retail investors start to believe that the trend is permanent and as a result, sell off their holdings.

The Bottom or the Top

For some time, the trend then goes on unobstructed. Let’s say after the initial obstruction, a downward trend will prevail for a while. Therefore the first 10% fall may have taken a while because of the fight between the bears and the bulls.

However, the next 15% or 20% fall in price may very well be a freefall. This is when the trend is at its strongest. This is also when more retail investors join the fray.

Also, this is the last stage of the trend. After this free fall, comes the bottom, wherein the prices reach either too high or too low. This is when the investing community wakes up and understands that the trend has taken a life of its own. Once people wake up to the absurdity of the trend, the trend literally dies!

The Reversal

The way up is slightly different. The first 10% virtually go unobstructed as the buy momentum is way stronger than the sell momentum. After a certain amount of momentum has been gained, the bull and bear fights resume and gains are smaller and more fiercely contested.

The basic direction of trends is known. However, the time that each stage will take is unknown. This is what makes the stock market extremely volatile in the short run.

Strategies to Deal with the Trend

The best strategy to deal with market trends is to stay away from them. Short term investing almost always causes losses. It is very difficult, if not outright impossible to time the market.

As an investor, one should be aware of the fundamentals that are driving the market. This will give a better idea as to whether the market is overvalued or undervalued. Trends almost always give the wrong signal and cause erosion in investor wealth.

Also, investors should ensure that they have sufficient risk tolerance when they invest in risky asset classes like equity. Making equity investments only to liquidate them at the slightest movement in the markets is a surefire way to lose money.

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