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Key Takeaways
Optimism, greed, fear, and panic—emotions rooted in neurological 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) and loss aversion, along with 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 statement 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 collective emotions shape financial markets. But what about the neurobiology that underlies 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 realize.
For example, the amygdala is the part of the brain responsible for processing fear and triggering fight-or-flight responses, which can lead us to make reckless decisions during market downturns. On the other hand, the ventral 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 based 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 a neurotransmitter known as dopamine.
Emotional phenomena such as fear of missing out (FOMO) often tend to amplify this trend. Fear of missing out (FOMO) stems from social reward pathways in the brain, as the human brain is designed to seek integration and avoid missing out on opportunities. Social media platforms, such as X and Reddit, can exacerbate the feeling of FOMO by showcasing stories of enormous gains, encouraging others to buy assets without a clear understanding of the risks involved.
Notable examples of this include meme coins like Dogecoin, Shiba Inu, and recently TRUMP and MELANIA, where the value of meme coins is, in most cases, driven by speculative momentum and social media trends rather than their intrinsic value. Traders often get swept up in this euphoria, ignoring warning signs 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 bearish trend, often resulting in 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 pleasure of equivalent gains.
As prices continue to decline, fear turns to panic, leading to capitulation, a point where investors collectively sell 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 market cycle in 2022.
The market ultimately stabilizes amid growing 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 hope and optimism.
The neurobiology behind market psychology
A series of complex neural processes shape the underlying psychology behind 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 you are exposed to a rewarding stimulus, your brain responds by releasing a lot of dopamine, which we typically see during bull markets, where dopamine pathways in the brain are activated by the 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 feelings of pleasure and reward. When anticipating financial gains, dopamine is released in this pathway, creating a sense of motivation and satisfaction.
The fundamental structure involved in processing emotions such as fear and anxiety is the amygdala, which is just as important during bear markets as dopamine pathways are during bull markets. The fight-or-flight response, which is typically a survival mechanism, can lead to reckless decision-making in financial contexts, often resulting in losses.
While fear and anxiety driven by the amygdala can negatively affect decision-making, leading to impulsive decisions such as panic selling, cognitive dissonance may also cause investors to cling to assets in denial, hoping that the markets will recover.
Cognitive dissonance occurs when traders' beliefs about the market conflict with reality. Cognitive dissonance is primarily associated with the prefrontal cortex, which is 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 lobe. Mirror neurons activate when a person performs an action and when they observe a similar action being performed by another person.
At its core, mirror neurons allow us to sense the feelings and actions of others; they are responsible for the feeling of empathy towards others and social influence. Observing other traders succeed can stimulate these neurons, leading to imitation, which may play a key role in herd instinct.
TRUMP Meme Coin: A Case Study
1. Rapid growth and dopamine pathways
The massive growth of the TRUMP meme coin at its launch was likely influenced by the brain's reward system. Factors such as the clear association with Donald Trump, a well-known figure of immense wealth, and the significant media coverage surrounding the cryptocurrency likely contributed to its initial price surge.
The fear of missing out (FOMO), along with the idea of losing potential rewards, may have also driven this impulse. This initial surge likely stimulated traders' dopamine pathways, releasing dopamine in anticipation of financial rewards, thus creating a feedback loop of excitement and speculation. This phase is also commonly referred to as the euphoria phase, where optimism and excitement fuel rising prices.
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 coin 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 feelings instead of independent rational analysis. In the case of TRUMP tokens:
Meme culture: Memes and activity on social media created a buzz that encouraged others to join this trend. Mirror neurons may have amplified the positive feelings among traders and investors.
Political engagement and fan base: Supporters of Trump and his fan base boosted the coin's visibility and popularity, leading to a rapid positive trend in the markets through these social interactions.
This highlights how herd instinct, driven by mirror neurons and reinforced by social influences like meme culture and fan base interactions, can drive market behavior.
3. Volatility, panic selling, and the amygdala
Following the initial surge in the coin's price, similar to most meme coins, TRUMP tokens also experienced significant volatility and a sharp decline in prices. At this stage, traders may suffer from denial, fear, and anxiety.
Cognitive dissonance may lead many to cling to their assets despite a market downturn, hoping for a quick recovery or believing in a specific figure. This conflict between reality and personal beliefs can lead to irrational decisions and financial losses.
Meanwhile, the amygdala, responsible for the fight-or-flight response, may amplify feelings of fear and anxiety, thus prompting traders to panic sell. The announcement of the competing MELANIA coin likely intensified these emotional reactions, underscoring how external factors can strongly influence individual investor behaviors, and thus market trends.
Concluding Thoughts
Understanding the psychology behind market cycles can be immensely important, as it provides better context for traders and investors to understand market trends. For example, you can monitor emotional trends to identify periods of extreme pessimism or optimism, and see how these feelings impact market prices.
Familiarity with the neurobiological processes underlying emotional trends, including the role of dopamine pathways, structures like 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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