Psychology

Disclaimer: This article is for educational purposes only. The information provided through Binance does not constitute advice or recommendation of investment or trading. Binance does not take responsibility for any of your investment decisions. Please seek professional advice before taking financial risks. Products mentioned in this article may not be available in your region.

Key Takeaways

Optimism, greed, fear, and panic, rooted in neurological processes, shape market sentiment and are directly related to uptrends and downtrends. 

Psychological pitfalls like FOMO, loss aversion, and cognitive dissonance often lead traders and investors to make irrational decisions. 

Social platforms can further amplify emotional swings, 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 just how much emotions and psychology drive market behavior. At the core of this idea lies market psychology, an important concept in behavioral economics that explores how the collective emotions of market participants shape financial markets. But what about the neurobiology that shapes market psychology itself? 

Neuroscience tells us that our brains aren’t as rational as we’d like to believe, especially when money is involved. Emotions, cognitive biases, and psychological processes often steer our financial decisions in ways we might not even realize. 

For instance, the amygdala is the part of the brain that processes fear and triggers fight-or-flight responses. It can push us to make impulsive decisions during market downturns. On the other hand, the ventromedial prefrontal cortex, which evaluates rewards, can fuel overconfidence during bull markets. 

These brain mechanisms, while essential for survival, often lead us to act on instinct rather than reason when it comes to trading and investing.

How Psychology Drives Market Cycles

Uptrend

Optimism is widespread during a bull market. Rising prices generate excitement, and neurobiology tells us that this triggers the brain's reward system, releasing the neurotransmitter dopamine. 

Emotional phenomena like FOMO (fear of missing out) tend to amplify this trend. FOMO stems from the brain’s social reward pathways, as we’re physically wired to seek inclusion and avoid missing opportunities. Social media platforms like X and Reddit can exacerbate FOMO by showcasing stories of massive gains, encouraging others to buy assets without fully understanding the risks.

Dogecoin, Shiba Inu, and most recently, the TRUMP and MELANIA meme coins serve as prime examples. The value of meme coins, in most cases, is driven by speculative hype and viral trends rather than intrinsic value. Traders are often swept up in the euphoria, ignoring warning signs like overvaluation or unsustainable growth.

Several neurobiological processes coincide to create this unchecked optimism, which can lead to financial bubbles, where prices far exceed an asset’s true value. When the bubble bursts, the market enters a downtrend, often triggering a cascade of negative emotions.

Downtrend

When the market reverses, emotions shift from optimism to denial and fear. The brain’s amygdala, which processes fear, takes over, prompting instinctive responses like panic selling. Neurologically, this fear is magnified by the loss aversion bias, which causes losses to feel more painful than equivalent gains feel rewarding.

As prices continue to fall, fear turns into panic, leading to capitulation, a point where investors sell their holdings en masse, often at significant losses. This behavior is particularly evident during bear markets, as seen in Bitcoin’s sharp corrections during the 2022 market cycle.

The market eventually stabilizes as pessimism peaks, often leading to an accumulation phase where prices move sideways. At this point, some investors may cautiously reenter the market, driven by reemerging feelings of hope and optimism.

Neurobiology Behind Market Psychology

A series of complex neurological processes shape the psychology behind market trends. One such process is the reward pathway, which consists of various neurotransmitters and brain structures.

The main neurotransmitter associated with rewards and pleasure is dopamine. When you are exposed to a rewarding stimulus, your brain responds by releasing increased dopamine. This is typically seen during bull markets, where the brain’s dopaminergic pathways are activated by the anticipation of financial rewards, thus creating a feedback loop. 

Source: Simplypsychology.org

Dopamine is primarily synthesized in the substantia nigra and ventral tegmental area. As seen above, there are multiple dopamine pathways through which dopamine travels to different regions of the brain.

The pathway most associated with market psychology is the mesolimbic pathway. The mesolimbic pathway connects the ventral tegmental area to the limbic system, which includes the amygdala. This pathway is central to experiencing pleasure and reward. In anticipation of receiving a financial gain, dopamine is released into this pathway, creating a sense of motivation and satisfaction.

The primary structure involved in processing emotions like fear and anxiety is the amygdala. The amygdala is as significant during bear markets as dopaminergic pathways are during bull markets. Typically a survival mechanism, the fight-or-flight response in financial contexts can lead to impulsive decisions, often resulting in losses.

While fear and anxiety triggered in the amygdala can distort decision-making processes and result in impulsive decisions like panic selling, cognitive dissonance can also influence investors to hold onto assets in denial, hoping that the market may recover. 

Cognitive dissonance is experienced when the beliefs held by traders about the market conflict with reality. Cognitive dissonance is primarily associated with the prefrontal cortex, responsible for higher-level cognitive functions, and the limbic system, which again includes the amygdala and the hippocampus.

Another interesting aspect of neurobiology that may influence market psychology is mirror neurons. These neurons are found in several areas of the brain, including the premotor cortex, the supplementary motor area, the parietal lobe, and the inferior parietal lobe. Mirror neurons fire both when an individual performs an action and when they observe a similar action performed by someone else.

In essence, mirror neurons allow us to experience the emotions and actions of others vicariously. These neurons are involved in empathy and social influence. Watching other traders succeed can trigger these neurons, leading to imitation, which may play a major role in herd instinct.

TRUMP Meme Coin: A Case Study

1. Rapid growth and the dopaminergic pathways

There is a good chance the explosive growth of the Trump meme coin at launch was influenced by the brain’s reward system. Factors like the clear connection to Donald Trump, a widely recognized figure of wealth, and the significant media coverage surrounding the coin likely contributed to its initial surge.

FOMO and the general thought of missing out on potential rewards was also a possible driver. This initial surge likely triggered the dopaminergic pathways of traders, releasing dopamine in anticipation of financial rewards and thus creating a feedback loop of excitement and speculation. This phase is also commonly referred to as the euphoria stage, where optimism and excitement fuel a price increase.

2. Herd instinct and mirror neurons

As discussed earlier, mirror neurons often play a role in herd instinct, and, thus, market psychology. The coin’s rapid growth may serve as an example of these neurons in action as individuals, influenced by the emotions and perceived success of others, may make decisions driven by collective sentiment rather than rational, independent analysis. In the case of TRUMP:

Meme culture: Memes and social media activity created a viral buzz that encouraged others to join the trend. Mirror neurons may have amplified positive emotions among traders and investors. 

Political and fanbase engagement: Trump’s political supporters and fanbase further propelled the coin’s visibility and adoption. A positive market sentiment is rapidly spread through these social interactions. 

This highlights how mirror neuron-powered herd instinct, amplified by social influences like meme culture and fanbase engagement, can drive market behavior.

3. Volatility, panic selling, and the amygdala

Following its initial surge, like most meme coins, TRUMP also experienced a great deal of volatility and sharp price drops. At this stage, traders may experience denial, fear, and anxiety. 

Cognitive dissonance may lead many to hold onto their assets despite the market's downturn, hoping for a quick recovery or faith in a particular figure. This conflict between reality and personal belief can result in irrational decisions and financial losses.

Meanwhile, the amygdala, which is responsible for the fight-or-flight response, may amplify feelings of fear and anxiety and thus drive panic selling. The announcement of the competing MELANIA coin likely heightened these emotional reactions and underscores how external factors can strongly influence individual investor behaviors and, as a result, market trends.

Closing Thoughts

Understanding the psychology behind market cycles can be highly valuable, providing better context of market trends to traders and investors. For example, you can observe emotional trends to spot periods of intense pessimism or optimism and see how such emotions affect market prices.

Being familiar with the neurobiological processes that underscore emotional trends, including the role of dopaminergic pathways, structures like the amygdala, and the function of mirror neurons, can give you a more in-depth understanding of market psychology. This may increase your chances of avoiding common psychological pitfalls like cognitive biases, FOMO, panic selling, and cognitive dissonance.

Further Reading

What Is the Official Trump Meme Coin (TRUMP)?

What Are Behavioral Biases and How Can We Avoid Them?

Five Risk Management Strategies

Disclaimer: This content is presented to you on an “as is” basis for general information and educational purposes only, without representation or warranty of any kind. It should not be construed as financial, legal or other professional advice, nor is it intended to recommend the purchase of any specific product or service. You should seek your own advice from appropriate professional advisors. Where the article is contributed by a third party contributor, please note that those views expressed belong to the third party contributor, and do not necessarily reflect those of Binance Academy. Please read our full disclaimer here for further details. Digital asset prices can be volatile. The value of your investment may go down or up and you may not get back the amount invested. You are solely responsible for your investment decisions and Binance Academy is not liable for any losses you may incur. This material should not be construed as financial, legal or other professional advice. For more information, see our Terms of Use and Risk Warning.

What is market psychology?

Market psychology is a set of ideas that price movements reflect or are influenced by the emotional state of participants. This is also one of the main topics of behavioral economics, or rather its parallel field of study, which studies the factors that precede various economic decisions.