“The dumbest reason in the world to buy a stock is because it’s going up.”

Warren Buffett

Action, intrigue, uncertainty, elation, and exasperation. I’m not talking about the latest box office thriller; I’m referring to the stock market. Despite its perplexing ups and downs, it affects us all, no matter what business we’re in. For that reason, improving our understanding of what drives it is essential. And what drives “the market” is that which drives all business— human psychology.

We all watched it happen last month. The stock market bounced up prior to Election Day, only to dramatically plummet the day after. The upswing reflected investors’ anticipation of a more “business friendly” Republican administration, while the drop reflected their disappointment with the reelection of President Obama. Both of these effects convey lessons regarding the kinds of forces that drive market activity, and they’re lessons well worth learning. 

It’s all about expectations

It didn’t take a financial genius to predict the market’s reaction to the election. What I found most interesting however, was the array of explanations offered for why. They’re too numerous and diverse to elaborate on here, but among those cited were policies associated with energy, healthcare, taxes, the federal government’s approaching “fiscal cliff”, and a whole host of other issues on which the two candidates’ thinking differed.

As diverse as these explanations were, they all shared a common element— they were all based on expectations. Expectations are psychological variables, which are themselves affected by factors that range from the tangible to the imaginary. Those who do well in the market are those who have the best understandings of the interface between human psychology and financial matters.

Take your cue from Warren Buffett

Financial genius Warren Buffett’s exploits as an investor are well known (that’s putting it mildly). Interestingly enough, he is a big fan of psychological research on expectancies and decision making, and actively makes use of consultants who specialize in that area. 

It works very well— Buffett’s accomplishments speak for themselves. His holding company, Berkshire Hathaway, thrives in spite of what appears to outsiders to be utterly chaotic and unpredictable market activity. It’s an astounding economic machine that displays incredible immunity to the volatility that stymies other investors.

At the time of this writing, a single share of Berkshire Hathaway preferred stock was $128,925.00 (up $765.00 since the opening bell). While most people associate the field of psychology with psychoanalysis, therapy, and Dr. Phil, Mr. Buffett and other successful entrepreneurs are putting the “business end” of the field to good use and banking the benefits.

Expectancies, risk, and reward: The stuff of business

In 2002, the interface between the field of psychology and the world of business really came to the fore. A Nobel Prize for Economic Science was awarded to Israeli-American psychologist Daniel Kahneman for his research on human decision making in situations involving risk and reward.

Economics as a field has traditionally emphasized rational thought as the basis for economic decisions. But rational thinking in and of itself is a poor predictor of many of the peculiar and seemingly irrational aspects of market activity. 

In contrast, Kahneman’s research in cognitive psychology explored the role of non-rational influences on decision-making. By doing so, he was able to account for peculiar effects in market activity in ways that are not only understandable, but are also predictive of many of the trends that otherwise appear to be inexplicable.

Ordering your thinking own about the market

If you really want to get a handle on what drives the stock market, think a little less in terms of dollars and cents and lot more about human life in general. What determines market activity may be reflected in all those charts and graphs, but it really resides in the heads and hearts of human beings. And human beings are driven as much by passions and fears as we are by logic.

Explaining mysterious market activity

The realities of psychological forces in the market were exemplified in recent history by the behavior of a couple of well known Internet based stocks. Both of these are in the potentially lucrative field of social media, and both stocks’ “IPOs” (initial public offerings) were announced with great fanfare and anticipation.

In 2011, LinkedIn stock went on sale in May at a cost of $45.00 a share. It was followed about a year later by Facebook, which went on sale at $38.00 a share. The buzz surrounding each offering was intense, with investors poised to get in on the ground floor of what could become the next Google or Priceline. The performances of these two stocks however, have been as different as night and day.

LinkedIn & Facebook:  One boom, one bust 

The value of LinkedIn stock took off the day it was offered, climbing from $45.00 a share to a closing price over $94.00. With all the ups and downs in the market since that time, LinkedIn has maintained a high value relative to its IPO, currently in the neighborhood of $100.00 a share. Those that got in on the ground floor were beneficiaries of the best that the market has to offer and exemplified the potential benefits of investing in social media based companies.

The performance of Facebook stock however, presents a stark contrast to that of LinkedIn.  Initially priced at $38.00 a share, on its first day on the market it sputtered, closing at $38.23. In subsequent months the stock dropped well below half its initial price. Between May and August 2012, Facebook, darling of the digital generation, had lost over 50 billion dollars in market capitalization.    

A lesson about how the market works

Taken together, these two cases present good illustrations of how market activity can appear irrational on the one hand and yet be perfectly understandable on the other. To understand what happened, one must (1) have the proper information and (2) understand the psychology of the participants.

An explanation then emerges as a variation on the simple idea of supply and demand. LinkedIn’s initial offering was $45.00, but fewer than 8 million shares were available for purchase. It was both a good stock and in short supply, a combination that made each share precious and valuable. The dollar value therefore shot up and continues to remain at a high level. 

Facebook’s executives, noting what had happened in the case of LinkedIn, got greedy, opting to make over 421 million shares available on its opening day. Epitomizing the concept of “too much of a good thing,” Facebook’s IPO has become a study in miscalculation.

Experienced investors saw the danger and stayed away from it altogether. Naive investors however, expecting that it would take off like a rocket, exemplified the old adage, “fools rush in.” Supply was far too high relative to the demand, so the price first stalled, then fell off rapidly. 

Facebook’s executive team is still wrestling with the problem of how to get its stock price to grow, but its bruised reputation has been difficult to heal.  

The value of doing your homework

Note that what appears on the surface to defy logic becomes predictable in light of the proper information. Note also the perils of being under-informed. Those who lost big in the “Facebook fiasco” were naïve investors who were operating on vague impressions and incomplete knowledge. But the lessons for those who wish to enhance their understandings of market workings are invaluable.

You can’t know too much about how the market works or the details of the companies available to invest in. Skimping on research and making decisions based on the idea of a “sure thing” are the two most common causes of bad choices. What appears to be a great investment can turn into a financial Frankenstein monster on you if you only think you know what you’re dealing with. 

Never jump in on any of the market’s frequent “feeding frenzies.” Someone will make money, but it probably won’t be you.

Back to Square 1: It’s all psychological

The stock market is a place where both logical thought and the illogic of passion, greed, and fear operate in concert to determine the economic fates of investors. Understanding financial factors is essential, but it’s not enough— you also need to be a functional market psychologist.   

Like chess, where you win by anticipating the moves of the other participant, the stock market is not for those who don’t like rules and don’t care how other people think. It requires what psychologist Daniel Goleman refers to as “emotional intelligence”— a good understanding of yourself as well as a keen awareness of the thinking of others.

Loving the “business of business”

If you just want money, the stock market is probably not for you. If, on the other hand, you are genuinely fascinated with organizations, people, the drama of real life, and have a love of learning, then maybe it is. I would also recommend that you have some appreciation for math. Above all however, you have to love business in its own right and for its own sake.

I do, and I find that being involved with the market puts me in touch with virtually every other aspect of human life— industry, entertainment, travel, food, health, technology, and even love are reflected in market activity to one degree or another. 

The fact that it affects all of us no matter what business we’re in behooves us to enhance our understandings of the market and its workings. And in doing so, we’ll all hopefully understand the world we live in— and ourselves— a little better as well.