Elliot Wave Part 1 – Investor Sentiment, Crowd Psychology And The Elliot Wave Theory
How about this one?
Chances are, if you’re a newbie investor (or you remember what it was like) the cycles depicted would feel familiar.
At least for me, those images pretty much sum up what I felt when I started investing in stocks.
But actually, it’s not just newbies that can succumb to it. Stock investing, by nature is a risky proposition, and no one ever truly knows what will happen next. Even those armed with Fundamental and Technical Analysis skills would be hard-pressed to accurately predict what would happen next. Simply put, there are times when you can tell and times when you cannot.
And that degree of uncertainty fuels people’s investing attitude.
Case in point: there’s no real reason for August to be brutally bad for stocks. But it’s called a ghost month. And there’s supposedly some historical data to back that up. There’s no real reason for it. But if people believe it, then it affects their judgement. So it becomes a self-fulfilling prophecy (at least after a cursory glance).
And did you notice how bad news in other Asian countries – and the U.S. especially – causes the PSEi to plummet, when in fact it has no effect on our companies’ business or profits?
And that’s the thing with the stock market. Fundamental Analysis will tell you that a stock is worth a bit more than it is currently selling for. But some news comes up and all of a sudden the price actually falls further.
Markets are driven by people. And people are driven by emotions. And that’s where Elliot Wave Theory comes in.
So what exactly is the Elliot Wave Theory?
It’s a form of technical analysis and thus relies mainly on price movement and pattern recognition. What’s different about it though is it basically has just two patterns (or four depending on how you look at it).
This is because Elliot Wave theorizes that people naturally shift between greed and fear. And as we saw from the infographics above, that’s somewhat true.
It further states that it moves in a predictable 5-wave pattern that looks like this:
|(Th reverse is true for a bear market)
So just how “good” is this theory? Well, it was discovered/developed by Ralph Nelson Elliott (in the U.S.) during the late 1930s. And when we look at the PSEi performance from 2004-2013(Aug):
|photo courtesy of www.tradingeconomics.com
Whoa! Except for the absence of wave 5, it’s eerily similar, right? That’s the reason Elliot Wave Theory can be compelling. It makes it look like the chaotic and unpredictable stock market is actually very predictable.
And to a certain degree it is. If you’ve been investing in the stock market, there are 2 basic principles that are never broken: what comes up must go down, and what goes down must come up; it’s only a matter of when.
But the theory also has it’s shortcomings. It doesn’t tell us when. While the pattern fits the PSEi perfectly, there’s nothing to tell us how long this wave 4 will last, or when wave 5 will start.
For example, the June dip to ~5,789 could have been the “bottom” of wave 4, and the July run up to ~6,800 could’ve been the start of wave 5. But now, we see that’s obviously not the case, since in August it dipped even lower to ~5,738. It was still in wave 4, based on the Eliot Wave Theory.
Another problem is it can have vague rules. For example, based on the chart above we can expect a wave 5 at some point. So even though we are on a downtrend, if we just sit still or even if we average down, we’re headed for greater profits in the future.
But actually, in one of the many guidelines of the Elliot Wave Theory, it says it’s actually possible to have a truncated wave. That means, wave 5 could be short-lived and not higher than wave 4 – so very little or even no profit for us.
But even so, I think the theory has it’s merits. For one, it shows the basic truth in the stock market: prices may fluctuate like crazy, but in the long-term it gives a good-to-great return on your investment if you just pick wisely and sit still.
And despite it’s shortcomings, having a rough guide that’s generally true most of the time can be quite useful.
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How To Invest In The Stock Market Series:
- How To Start Investing In The Philippine Stock Market
- How You Should Evaluate Your Stock Broker
- An Overview On Technical Analysis for The Stock Market
- Position Sizing – Or How Not To Lose Your Shirt In The Stock Market
- An Overview Of Fundamental Analysis For The Stock Market
- Elliot Wave – Investor Sentiment, Crowd Psychology, And The Stock Market
- 6 Stock Investing Strategies – Which One Fits You?
- Different Strategies For Bull Markets, Consolidation & Bear Markets
- When Should I Sell My Stock?
- Learnings from the Stock Market