The psychology that drives stock prices

I wouldn’t really know where to start with the myriad of complex fundamental variables, profit and loss, balance sheets, return on equity, cash flow, sales and earnings growth, it’s somewhat of a mire of confusion for me. I understand and respect the tangible nature of fundamentals but the connection to the ups and downs of price movement eludes me.

But that’s not what this article is about. It is about what actually drives those stocks prices up and down, which is often at odds with fundamental valuations, and finding a form of analysis that suits you and maximises returns. One that enables us to trade in and out of stocks as prices fluctuate.

This is an important starting point if we are to trade shares successfully. What rings your bell, what resonates with you and more importantly what works for you? I had always found it hard to match fundamental analysis with the price movement. Using fundamental analysis to help me make money on stocks simply wasn’t working nor was it effective.

I needed to find another way. Then the light went on! If I was to make money trading stocks, then why not go the core of the issue and analyse the very thing that meant the difference between profit and loss – the price itself.

And there began my love affair with price analysis. Understanding the psychology behind what drove prices fascinated me. The road I chose to take was very much based on an understanding of human behaviour which never really changes. It is repetitively readable. And when focusing on the emotions of fear and greed it is even more clearly repetitive.

Price movement is a reflection of our behaviour as humans. Price behaviour is about our perceptions. Share price movement is driven by perceptions and a shared view at any point in time of what a share is worth or more importantly what it is going to be worth in the future. If our perception is that is it cheap, we are going to buy it. If our perception is that it is expensive, we are going to sell it. Everyone has a (different) perception and basis for buying or selling.

As humans we take comfort in what others are doing (crowd behaviour – tulip mania, internet boom) and this can drive prices to excesses of fear – low points – and greed – high points. These excessively high or low values are often far away from what fundamental values would ever imply, but they occur. We can call this the X factor. (Fundamental value +/- X) = excess prices. Excessive prices offer great profit opportunities. Under these circumstances price moves far and fast.

Normal human behaviour easily attains the emotion that anything is possible and that the sky is the limit, and this is very much propelled by the crowd behaviour phenomenon. There are many share price chart examples that endorse this proposition.

Perceptions drive excessive price movement



Price acceleration and trends

At some stage when these excesses take share prices into the stratosphere reality comes crunching down on them and brings the price back to earth.  This ‘bust’ is also a part of the normal cycle of human emotion that drives prices and we need to identify that change to ensure we capitalise on the price surges and make money from the excessive behaviour. I will look at this aspect and the ‘control’ of trading required to make this profit opportunity a reality in future articles.

Identifying price patterns based human psychology can offer a unique insight into price movement and provide a special ‘edge’ when assessing and determining the likely force and direction of price movement.