(This article was first published in Making Smalltalk.)

Humans are emotional fools. I don’t mean to be condescending, but that is the truth. We humans allow our emotions to run amok quite often and that hardly ever ends with us in a good place.

Whenever we are able to keep our emotions in check, we are able to take better decisions. These are decisions about our life, our work and our money. When our investment are concerned, removing emotions can result in better decisions.

When we allow emotions to affect our investment decisions, we allow ourselves to become victims of certain behavioural biases. These biases make us take decisions that are based on feelings, rather than facts.

A study carried out by H. Kent Baker and Victor Ricciardi, co-authors of the book ‘Investor Behavior: The Psychology of Financial Planning and Investing’, details popular behavioural biases and how they make our investment decisions emotional.

  • The joy we get from making one good investment leads to overconfidence in believing we can’t fail. On the opposite end, a bad investment is blamed on external factors. This is called self-attribution bias.
  • Being fearful during bear market phases makes us procrastinate and miss out on investment opportunities. This is called worry bias.
  • Not letting go of our preconceived notions can lead us to hold onto non-performing investments even after their fundamentals have changed. This is called confirmation bias.
  • One poor investment decision can result in complete aversion to risk to avoid further negative outcomes. This is called regret aversion bias.
  • Having a preference for familiar or well-known investments can make us ignore better options that could work out better. This is called familiarity bias.
  • Chasing past performance and expecting the same to continue even though aspects of the investment may change can lead to poor decisions. This is called trend-chasing bias.

Needless to say, any investments that we make under the influence of these biases or emotions are less likely to turn out to be beneficial for us. This is why we have to keep our emotions out of our investment decisions.

An investor should of course follow the basics–evaluate the fundamental and technical aspects of a stock before investing in it, not invest on the basis of tips, have a diversified portfolio and invest with a long-term mindset.

Sensing the mood of the markets

But even with all of that, it often becomes difficult to buy or sell a stock investment. Taking an investment call becomes even more difficult in a volatile market. This is where the smallcase Market Mood Index can help.

The Market Mood Index (MMI) is a scale from 0 to 100 that measures the sentiments of the stock markets. The scale begins in the ‘extreme fear’ zone and goes up to ‘extreme greed’.

MMI is built on the Warren Buffett quote–Be fearful when others are greedy and greedy when others are fearful. When the market sentiment is fearful, it would make for a good buying opportunity for long-term investors. Similarly, if you’re looking to redeem for a goal, you can do so if the markets are greedy.

The index takes into account seven important factors like FII activity, volatility, price strength, demand for gold, etc to give an estimate of how the emotions are driving the market.

The Market Mood Index, which is updated every 3 minutes, can be used to time the street in a more effective manner. However, it should not be used solely as a recommendation engine.

Check out the Market Mood Index on mmi.smallcase.com.