Psychology: the FOMO phenomenon in trading

Let’s take a look at the psychological phenomenon known as “FOMO”. You may have read blogs or seen stock market programmes in which the commentators have used the term “FOMO”. What does “FOMO” mean exactly, and what does it have to do with trading?

1. WHAT IS FOMO?

“FOMO” is the acronym of the expression “Fear Of Missing Out“. This term is used to describe the feeling of anxiety that some people experience at the idea of missing out on opportunities. It is a feeling of frustration that we are confronted with in a number of everyday contexts.

To give an example, have you ever experienced anxiety at the thought of missing out on a trend or fad?

Perhaps there was a time when all your friends bought tickets to the concert of the century, or they were all wearing the latest trendy fashion accessory, so you dashed out to buy the same item out of fear at missing out and looking like the nerd of the group.

Businesses often play on this phenomenon and strive to create this feeling as part of their marketing strategy. A company presents a very attractive product, puts it on special offer, and announces that “the number of copies will be limited to the first 100 to arrive”, or “the offer will expire within 48 hours”. Frustrated by the fear of not obtaining the product that you want so much, you rush out of the house, hoping to get to the shop before it’s too late.

2. THE FOMO ON THE STOCK MARKET

This same phenomenon also applies to the financial markets.

It is a psychological bias that traders may be confronted with, whether they are individual traders or professional and institutional investors.

What to do when the price of an index, a share, or any other security, suddenly goes up in an increasingly upwards trend?

Let’s put ourselves in the shoes of a trader who suddenly notices that his/her chart is rising at an increasingly rapid pace, without him/her being in the race.

The frustration that this can cause has a direct impact on the mindset of our trader who helplessly watches the opportunity he/she has just missed out on, and the potential latent gains that could have been made. If only he/she had been in on the action…

In this scenario, should our trader remain stoic and impassive, or should he/she get into the action in the hope of making profits too?

There are several possible courses of action:

• The trader abstains from any action. This is the wisest decision, but paradoxically the most difficult one to take, as it is the most frustrating!
• Alternatively, the trader takes the opposite course of action and out of pure annoyance and revenge at having missed out on the first opportunity, refuses to risk missing out on the next one! The trader runs the risk of being alone again, trading against the other traders, and being swept away by the general movement.
• The trader jumps into the collective movement, following like a sheep. The trader justifies this action by saying that an opportunity like this may not come around again soon. The trader runs the risk of entering into the market too late and finding himself/herself at the top of the curve just as the market starts to correct itself.

It is true that we often say “markets don’t rise to the sky”, but also remember that “markets can rise much higher than you will be creditworthy!”

The challenge lies in identifying a healthy uptrend that has moments of decline, perhaps entering into a range trend before rising again and reaching new highs, which is not the same as a sudden, straight and euphoric market explosion.

Blindly following a FOMO phenomenon is often not the best solution. Patience is sometimes the best way forward, know when to take a break from the platform, take a step back and clear your mind, avoid jumping on the bandwagon with a gut reaction, wait for a qualitative signal before taking a position, at the risk of getting burnt, whichever direction the trend is taking.

However… self-control is not always easy to apply in this context and will probably require some dedicated self-work. It is often said that mastering the psychological factor of trading is key to success in the financial markets.

3. ARE THE MARKETS CURRENTLY IN A FOMO BIAS?

Let’s take a quick look back at the market situation… As you probably know, there was a very sharp fall in December 2018, but the markets are now rising steadily again. Although there have been several corrective movements during the year.

If we take the example of the American markets, which are said to lead all the others, we saw the fastest downturn on Wall Street for a month of December (in terms of percentage of indices) since the 1930s! Between 1 and 24 December 2018, the Dow Jones was down 16%.

However… after hitting an annual low, everyone started buying back on December 26, 2018. The next day, as the upward correction continued, the institutional collective jumped on board.

Whether it’s investment funds that are fond of highly speculative assets, the so-called hedge funds, or institutions that don’t use leverage, such as pension funds, endowments, foundations, etc., in other words, those that invest over the very long term, when all of these investors jump on the bandwagon, the market inexorably rises up and up and up.

At the very end of 2018, the Dow Jones recovered 1000 points in one hour before closing.

In the following months, while the indicators were not always at their best, many still weren’t confident in the rise, many expected a fall… but that didn’t happen…

Sometimes it is the fund managers who, in the interests of performance, feel obliged to buy risky assets to please their clients, for whom only performance matters. The same goes for non-speculative funds, which are often obliged to buy to meet their objectives.

In these situations where traders are not confident in the market’s rise due to a lack of solid economic factors, but where they resign themselves to buying, because that is what everyone else is doing, are at the origin of euphoric movements, or even speculative bubbles that are disconnected from the actual economy.

For months, the markets were blindly embracing rumours of rate cuts and the possibility of an agreement between China and the US. Despite a few unsettling tweets that triggered profit-taking, the indices always rally at the slightest accommodating statement.

Since the peak of volatility, reached in the summer of 2019, the markets have recovered, as phase 1 of the agreement between the two economic powers, China and the US, has been incorporated. These equity and index markets have continued to operate since autumn 2019 on the basis of the accommodative policies of the central banks, which have considerably lowered their lending rates and injected a lot of liquidity.

The US Federal Reserve has, at this point, injected hundreds of billions of dollars in several months. Not to mention the People’s Bank of China, which injected more than 2,000 billion yuan in one week to compensate for the panic in the markets caused by the coronavirus epidemic.

Despite a lack of visibility on the financial health of companies, despite macroeconomic indicators that are far from outstanding, and despite stressful catalysts such as tensions between the US and Iran/Iraq at the beginning of 2020, Brexit or the coronavirus, you will have noticed that each stressful phase over the last few weeks has been offset by a sharp rebound.

Several benchmarks seem to rise only because of the systematic buying of futures. One only has to look at the vertical rises in index futures during the middle of the night, as well as the gaps at the equity market openings.

When it’s not futures, it’s the intense speculation on some of the world’s strongest stocks that is driving the gains.

These FOMO phenomena can be clearly seen on indices such as the S&P500, the NASDAQ 100, or on certain stocks, such as Tesla.

CONCLUSION:

For an individual trader, blindly following a FOMO phenomenon can generate considerable levels of frustration and even send you into a downward spiral of overtrading. Taking a step back can be challenging, but is often necessary to avoid jeopardising your capital.

As far as the current markets are concerned, despite the alarms that have been raised for months, if not years, by the same pessimists, the equity markets are rising faster than others. This is happening in the midst of an uncontrolled health crisis that has yet to reveal its full impact on the global economy. It makes you wonder what signals will be sufficiently brutal to bring down the indices, which are increasingly resistant to any correction. Although we are never without risk of a crash…

In a context where the equity market is saturated with liquidity, which for the moment no longer seems to be concerned about risk-pricing, it is possible that the FOMO effect will persist until a disproportionate “Bull Market” is generated, a total capitulation of sellers taking an even more vertical direction.

Who knows if the market has the potential to skyrocket further. Perhaps even reaching the next psychological levels? Like a DOW JONES at 30,000, a Nasdaq at 10,000, an S&P at 4,000, a CAC at 7,000 or a Dax at 140,000, etc.

Or will reality and fear of risk eventually take over the markets when the figures of the next few months give their verdict, as it is often in these FOMO contexts that speculative bubbles are born. We will certainly be discussing these phenomena further in our future blogs.

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