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Key Takeaways
Optimism, greed, fear, and panic—emotions rooted in neural processes—shape market trends and are directly linked to bullish and bearish trends in the markets.
Psychological fears, such as fear of missing out (FOMO), fear of loss, and cognitive dissonance, often drive traders and investors to make irrational decisions.
Social media platforms can amplify emotional volatility, while mirror neurons contribute to collective behaviors, herd instinct, and speculative trading.
Introduction
Warren Buffett once said, "The market is a device for transferring money from the impatient to the patient." This simple phrase highlights how much psychology and emotions drive market behaviors; at its core lies the concept of market psychology, an important concept in behavioral economics that explores how the collective emotions of individuals shape financial markets. But what about the neurobiology that shapes market psychology itself?
Neuroscience tells us that the human brain is not as rational as we would like to believe, especially when it comes to money. Emotions, cognitive biases, and psychological processes often guide our financial decisions in ways we may not be aware of.
For example, the amygdala is the part of the brain responsible for processing feelings of fear and triggering fight or flight responses, which can lead us to make rash decisions during market downturns. On the other hand, the ventromedial prefrontal cortex, which assesses rewards, can fuel overconfidence during bull markets.
While these brain mechanisms are essential for survival, they often lead us to act on instinct rather than logic when it comes to trading and investing.
How Psychology Drives Market Cycles
Bullish Trend
Optimism is widespread during bull markets, and rising prices create a sense of excitement, and neuroscience tells us that this stimulates the brain's reward system, leading to the release of the neurotransmitter known as dopamine.
Emotional phenomena such as fear of missing out (FOMO) often tend to amplify this trend. The fear of missing out (FOMO) arises from social reward pathways in the brain, as the human brain is designed to seek inclusion and avoid missing out on opportunities. Social media platforms, such as X and Reddit, can exacerbate feelings of FOMO by showcasing stories of huge gains, encouraging others to buy assets without a clear understanding of the risks.
Some of the most notable examples of this are meme coins like Dogecoin, Shiba Inu, and more recently TRUMP and MELANIA, where the value of meme coins, in most cases, is driven by speculative momentum and social media trends rather than their intrinsic value. Traders often get swept up in this euphoria and ignore warning signals such as overvaluation or unsustainable growth.
Many neurobiological processes coincide to create this unchecked optimism, which can lead to financial bubbles where prices far exceed the true value of the asset. When the bubble bursts, the market enters a downward trend, often leading to a series of negative emotions.
Bearish Trend
When the market reverses, emotions shift from optimism to denial and fear. The amygdala, responsible for processing fear, takes charge and triggers instinctive responses such as panic selling. Neurologically, this fear is exacerbated by loss aversion bias, which makes losses feel more painful than the happiness felt from equivalent gains.
As prices continue to fall, fear turns into panic, leading to capitulation, a point where investors collectively sell off their holdings, often at significant losses. This behavior is particularly evident during market downturns, as seen in the sharp corrective trend of Bitcoin during the 2022 market cycle.
The market eventually stabilizes with increasing pessimism, often leading to an accumulation phase where prices move sideways. During this phase, some investors may cautiously re-enter the market, driven by a return of feelings of hope and optimism.
The neurobiology behind market psychology
A series of complex neural processes shape the psychology underlying market trends. One of these processes is the reward pathway, which consists of several neurotransmitters and different systems in the brain.
Dopamine is the primary neurotransmitter associated with rewards and pleasure. When exposed to a rewarding stimulus, your brain responds by releasing a lot of dopamine, and we usually see this during bull markets, where dopamine pathways in the brain are activated by expectation of financial rewards, thus creating a feedback loop.
Dopamine is primarily produced in the substantia nigra and the ventral tegmental area. As seen in the figure above, there are many dopamine pathways through which dopamine travels to different areas of the brain.
The pathway most associated with market psychology is the mesolimbic pathway, which connects the ventral tegmental area to the limbic system, which includes the amygdala. This pathway is essential for feeling pleasure and reward. When anticipating financial gains, dopamine is released in this pathway, creating a feeling of motivation and satisfaction.
The underlying structure involved in processing emotions such as fear and anxiety is the amygdala, which is no less important during bear markets than dopamine pathways are during bull markets. The fight or flight response, which is usually a survival mechanism, can lead to rash decisions in financial contexts, often resulting in losses.
While the fear and anxiety triggered by the amygdala can negatively affect decision-making, leading to rash decisions such as panic selling, cognitive dissonance may also affect investors to hold onto assets in a state of denial, hoping that markets will recover.
Cognitive dissonance occurs when traders' beliefs about the market conflict with reality. Cognitive dissonance is primarily associated with the prefrontal cortex, responsible for higher cognitive functions, and the limbic system, which also includes the amygdala and hippocampus.
Another interesting aspect of neurobiology that may also affect market psychology is mirror neurons. These neurons are found in many areas of the brain, including the premotor cortex, supplementary motor area, parietal lobe, and inferior parietal lobule. Mirror neurons activate when a person performs an action and when they observe a similar action performed by another person.
At their core, mirror neurons allow us to sense the feelings and actions of others, and they are responsible for feeling empathy toward others and social influence. Observing other traders achieve success can stimulate these neurons, leading to imitation, which may play a key role in herd instinct.
Meme Currency TRUMP: A Case Study
1. Rapid Growth and Dopamine Pathways
The massive growth of the Meme Currency TRUMP at its launch was likely influenced by the brain's reward system. Factors such as the obvious connection to Donald Trump, a notoriously wealthy figure, and the significant media coverage surrounding the cryptocurrency likely contributed to its initial price surge.
Fear of missing out (FOMO) and the idea of losing potential rewards were also likely driving factors. This initial surge likely stimulated dopamine pathways among traders, leading to dopamine release in anticipation of financial rewards, thus creating a feedback loop of excitement and speculation. This phase is commonly referred to as the euphoria stage, where optimism and excitement fuel price increases.
2. Herd Instinct and Mirror Neurons
As discussed earlier, mirror neurons often play a role in herd instinct, and thus in market psychology. The rapid growth of the currency may serve as an example of how these neurons work, as individuals, influenced by the emotions and successes of others, may make decisions driven by collective emotions rather than independent rational analysis. In the case of TRUMP tokens:
Meme Culture: Memes and activity on social media created significant buzz that encouraged others to join this trend. Mirror neurons may have amplified positive emotions among traders and investors.
Political Engagement and the Fanbase: Political supporters of Trump and his fan base boosted the currency's visibility and popularity, leading to a rapid positive trend in markets through these social interactions.
This highlights how herd instinct, driven by mirror neurons and enhanced by social influences such as meme culture and fanbase interactions, can drive market behavior.
3. Volatility, Panic Selling, and the Amygdala
After the initial price surge of the currency, similar to most meme coins, TRUMP tokens also experienced significant volatility and a sharp decline in prices. At this stage, traders may experience denial, fear, and anxiety.
Cognitive dissonance may lead many to hold onto their assets despite the market downturn, hoping for a quick recovery or believing in a specific personality. This clash between reality and personal beliefs can lead to irrational decisions and financial losses.
Meanwhile, the amygdala, responsible for the fight or flight response, may heighten feelings of fear and anxiety, thus driving traders to panic sell. The announcement of the competing MELANIA currency likely intensified these emotional reactions, emphasizing that external factors can strongly influence individual investor behaviors, and thus market trends.
Concluding Thoughts
Understanding the psychology behind market cycles can be critically important, as it provides a better context for traders and investors to understand market trends. For example, you can observe emotional trends to spot periods of extreme pessimism or optimism and see how these emotions affect market prices.
Familiarity with the neurobiological processes that underpin emotional trends, including the role of dopamine pathways, structures such as the amygdala, and the function of mirror neurons, can provide you with a deeper understanding of market psychology. This could increase your chances of avoiding common psychological traps such as cognitive biases, fear of missing out (FOMO), panic selling, and cognitive dissonance.
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