• Subscribe
  • Log In
  • Home
  • Daily Diary
  • Asset Class
    • U.S. Equity
    • Fixed Income
    • Global Equity
    • Commodities
    • Currencies
  • Sector
    • Basic Materials
    • Consumer Discretionary
    • Consumer Staples
    • Energy
    • Financial Services
    • Healthcare
    • Industrials
    • Real Estate
    • Technology
    • Telecom Services
    • Transportation
    • Utilities
  • Latest
    • Articles
    • Video
    • Columnist Conversations
    • Best Ideas
    • Stock of the Day
  • Street Notes
  • Authors
    • Bruce Kamich
    • Doug Kass
    • Jim "Rev Shark" DePorre
    • Helene Meisler
    • Jonathan Heller
    • - See All -
  • Options
  • RMPIA
  • Switch Product
    • Action Alerts PLUS
    • Quant Ratings
    • Real Money
    • Real Money Pro
    • Retirement
    • Stocks Under $10
    • TheStreet
    • Top Stocks
    • TheStreet Smarts
  1. Home
  2. / Investing

How to Trade an Irrational Market

The crowd of investors is often irrational, but most of the time it's right.
By JAMES "REV SHARK" DEPORRE
Feb 04, 2023 | 10:00 AM EST

If the stock market could be navigated based on simple logic and common sense, then smart computer programmers would control the world. They would just program in the logical responses to certain circumstances and wait for the market to react as predicted.

Fortunately for us humans, it isn't that easy. Navigating the stock market is tremendously difficult in large part because it doesn't think or feel like a normal individual. It is wildly emotional and irrational at times, and common sense will often lead to very wrong conclusions. As the economist John Maynard Keynes is credited with saying, "the market can remain irrational longer than you can remain solvent."

Crowd Psychology

To complicate matters, what drives the market isn't the emotions and psychology of a single individual. It is the emotions and psychology of a crowd. Crowd psychology tends to be even more extreme and can seemingly be wildly irrational when compared to the thinking of any one individual.

The biggest mistake many traders make is treating the market like it is a logical and reasonable person. You have to treat it like it is a crazy person or a crowd of very emotional people.

The market isn't random. It always has logic, but that logic may not be readily apparent much of the time. It is like the person that hears voices that make perfect sense to them but drives behavior that others can't understand.

How do traders use this irrationality and emotionality to their benefit? There are two basic views of crowd psychology. The first is that market players, as a crowd, are overly emotional and delusional. The second view is that the crowd possesses special a wisdom and insight that individuals lack.

Two classic books address these two positions. The first is Extraordinary Popular Delusions & the Madness of Crowds by Scottish journalist Charles Mackay which was written in 1841. He discusses economic bubbles, including the Dutch tulip mania of the 17th century, and observes that "Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

The second book is 2004's The Wisdom of Crowds by James Surowiecki. He theorizes that crowds make better decisions because they can aggregate a great amount of information they obtain separately. In essence, it is decision-making by a huge research committee that has far more knowledge than any individual, or small group can possess.

Traders who focus on calling market turns tend to embrace the Mackay view of crowds. They see crowds as inevitably producing excesses as emotions build and the fear of being left out takes hold. Without question, bubbles like the Internet hysteria in 1999 to 2000 were created by this sort of behavior - even the action of the past week has elements of this herd mentality.

Running With the Heard

Momentum traders tend to embrace a different view of the crowd of investors. While the crowd may become irrational and downright hysterical at extremes, the vast majority of the time, the great mass of investors is correct. The way to make money isn't to bet against the herd but to run with it, and profit from its insight.

The current market environment illustrates how the crowd has possessed superior insight in the short term. You have done very well if you have stuck with the trend while the pundits have focused on how irrational the bullish thesis has been.

The contrarians who keep arguing that the masses are wrong and that this market will eventually undergo a substantial correction will likely be proven right at some point, but they fail to appreciate that the crowd has been right for over five years.

Market pundits tend to believe that they possess some superior insight that the crowd is too stupid to see due to emotionality and groupthink. They believe the crowd is blind to the obvious, but the truth is that the crowd can stick with their convictions and carry the market much further than an individual thinks is rational.

The market is largely an exercise in group psychology, but what most people tend to forget is that the crowd is much smarter than individuals are most of the time. It is only at extremes when the herd becomes delusional and is likely to lead us astray.

Get an email alert each time I write an article for Real Money. Click the "+Follow" next to my byline to this article.

At the time of publication, James "Rev Shark" DePorre had no position in the securities mentioned.

TAGS: Investing | Markets | Stocks | Trading

More from Investing

The Chasing Slows on Wall Street

James "Rev Shark" DePorre
Mar 24, 2023 4:34 PM EDT

After Deutsche Bank shakes up investors, market cools a bit, which might be a healthy development.

Stay Away From These Types of Stocks, They're Radioactive

Jim Collins
Mar 24, 2023 2:35 PM EDT

Here's what you're better off buying. I certainly have.

GE Looks Poised for a Pullback: How to Trade It Now

Bruce Kamich
Mar 24, 2023 1:45 PM EDT

The shares stopped short of my price targets.

See SPOT Run ... Down

Bruce Kamich
Mar 24, 2023 1:23 PM EDT

Spotify looks like it is poised for a downside price correction, according to the charts.

Expedition Everest RE: Let's Scale the Reinsurer's Charts

Bruce Kamich
Mar 24, 2023 12:35 PM EDT

Share prices quickly turned lower in March.

Real Money's message boards are strictly for the open exchange of investment ideas among registered users. Any discussions or subjects off that topic or that do not promote this goal will be removed at the discretion of the site's moderators. Abusive, insensitive or threatening comments will not be tolerated and will be deleted. Thank you for your cooperation. If you have questions, please contact us here.

Email

CANCEL
SUBMIT

Email sent

Thank you, your email to has been sent successfully.

DONE

Oops!

We're sorry. There was a problem trying to send your email to .
Please contact customer support to let us know.

DONE

Please Join or Log In to Email Our Authors.

Email Real Money's Wall Street Pros for further analysis and insight

Already a Subscriber? Login

Columnist Conversation

  • 01:56 PM EDT PETER TCHIR

    Very Cautious

    I am very cautious here. I don't like how the c...
  • 08:58 AM EDT JAMES "REV SHARK" DEPORRE

    This Weekend on Real Money

    How to Adjust Your Trading Style as Market Conditi...
  • 05:00 PM EDT CHRIS VERSACE

    AAP Podcast on the Fed Decision!

    Listen here!
  • See More

COLUMNIST TWEETS

  • A Twitter List by realmoney
About Privacy Terms of Use

© 1996-2023 TheStreet, Inc., 225 Liberty Street, 27th Floor, New York, NY 10281

Need Help? Contact Customer Service

Except as otherwise indicated, quotes are delayed. Quotes delayed at least 20 minutes for all exchanges. Market Data & Company fundamental data provided by FactSet. Earnings and ratings provided by Zacks. Mutual fund data provided by Valueline. ETF data provided by Lipper. Powered and implemented by FactSet Digital Solutions Group.

TheStreet Ratings updates stock ratings daily. However, if no rating change occurs, the data on this page does not update. The data does update after 90 days if no rating change occurs within that time period.

FactSet calculates the Market Cap for the basic symbol to include common shares only. Year-to-date mutual fund returns are calculated on a monthly basis by Value Line and posted mid-month.

Compare Brokers

Please Join or Log In to manage and receive alerts.

Follow Real Money's Wall Street Pros to receive real-time investing alerts

Already a Subscriber? Login