You can be one of at least three different kinds of investor. Two of them — fundamental and technical — will be familiar. The first focuses on company fundamentals as the driver of price. The second focuses on past volume and price action as the primary predictors of future price. Here’s what I take to be a third approach.
The Fundamental Investor
You trust in the power of analyzing a business — and especially its future cash flows — to decide how much it’s worth, and you make your investment decisions accordingly. You don’t care whether other people disagree with you about a business’s fundamental value, and perhaps your contrarian streak rather likes it. You probably pay some attention to macroeconomic factors, at the very least to the extent that macroeconomic and individual sector views are implicit in your estimates of future cash flows from any given business. You don’t care much for the old truism that the market can stay irrational longer than you can stay solvent: value is value, and any given occasion of the market’s failure to grasp value is nothing more than a temporary deviation. If ongoing market craziness flushes you out of a position this time, you’re confident the fundamental approach will make it up in the long run. You believe that when you’re operating at your best, your own emotions and psychology play no role in your investment decisions.
The Technical Investor/Trader
You believe that aggregate data about price and volume action give you insight into psychological factors driving both the past and the future behavior of other investors. When making investment decisions, the insight which you believe you have into other investors’ psychological imperatives takes precedence over macroeconomic or company-specific fundamental factors. You strive to ensure that your own emotions and psychology play little or no role in your investment decisions, and you take satisfaction in using ‘quantitative’ means to profit from the psychological imperatives of other investors as revealed to you through price and volume patterns. You might even have co-opted that term ‘quantitative’ for your brand of technical analysis, with other investors merely bumbling about non-quantitatively. Every now and again (especially if you’ve been dipping into formal logic or the philosophy of science), you might suspect that technical analysis plays a little loosely with the typical structure of scientific explanation. But since so many people seem to share your faith in predictions of the market’s future based on its past price, volume, charts, trendlines, support and resistance levels, patterns (wedges, triangles, head and shoulders, cup and handle, flag and pennant, etc.) and other factors, you figure there must be something to it.
The Psychological Investor
You believe in fundamental business analysis and all that factors into it. But you also believe that understanding something about human psychology can help in the job of identifying situations where the collective effect of investors’ behavior deviates from the rational in such a way that an asset becomes temporarily mispriced relative to its fundamentals. Contrariwise, you believe it can help to identify situations where the collective effect of such behavior is likely to revert to approximately rational over a reasonable period of time, consequently reducing or eliminating the mispricing. Identifying a business which is underpriced on a fundamental basis is not by itself sufficient to prod you into establishing a long position: you also want reason to believe the underpricing is likely to decrease within a reasonable time horizon. Likewise, identifying an overpriced business is not sufficient to establish a short position: you also want reason to believe that the factors responsible for the asset’s overpricing are likely to be rectified during an acceptable time frame.
Most importantly of all, you also recognize that quite a bit of price action has no more to do with psychology than it does with fundamentals; emergent properties of complex dynamical systems account for much of the remainder, and there is no need to have recourse to psychological explanations just because some bit of market activity looks, superficially, somehow ‘psychological’. Nor do you see any need to have recourse to psychological explanations couched at the same level of the description as that of the market itself — such as those routinely offered by technical analysts.
In terms of your own investment decisions, you recognize that emotions and individual psychology are ever-present, and rather than attempting to eliminate them, you prefer to try and understand their roles. Ironically enough, you are arguably more rational because of that recognition than you would be if you believed — in the fact of strong conceptual and empirical evidence to the contrary — that you actually could extinguish emotion and individual psychology from investment decisions. (After all, even turning over the job of trading to an algorithm always and necessarily involves a human decision as to which algorithm operating under which boundary conditions.)
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