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Chapter 3. Patterns and Predictions > Investors and Trends

Investors and Trends

Investors do not believe that the stock market is random. As such, investors tend to behave as if a stock price trend will continue rather than reverse. This is an outcome of the representative bias discussed in Chapter 2, “Behavioral Finance.” As an example, consider the responses of investors who are asked whether the direction of the stock market in the next six months will be bullish, bearish, or neutral. The American Association of Individual Investors (AAIIs) asks 125 of its members this question every week. The members are randomly selected from the AAII's vast membership. The investors' responses are very closely related to the direction of the market in the week(s) before the investors receive the survey question.[3] That is, if the investors receive the question after a run-up in the stock market, then they report a belief that the market will be bullish for the next six months. On the other hand, if the question follows a decline in the market, then investors forecast a bear market in the next six months. Investors predict that the current trend will continue.

Extrapolating from past trends is commonly done utilizing sophisticated types of trends. Instead of a linear upward bull market or downward bear market, investors also look for other patterns. For example, in discussions with investors, many have told me similar stories of a stock trading in a specific range. They notice that a company's stock tends to drop to a low of $18 and then climbs back to $25, only to fall back to $18. The investor usually has a simple trading strategy of buying at the low and then selling at the high part of the range. These investors have a strong belief in the continuation of this cycle. Indeed, an entire part of the investment industry is dedicated to looking for stock price patterns in the assumption that these patterns will continue and profits can be made. Specifically, the technique called charting is concerned with finding these repeating patterns.


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