Fear: The Primary Driver of Market Corrections

Fear and greed are the two primary drivers of investor behavior in the stock market, with fear being the stronger one. Greed grabs one investor at a time: someone sees a stock going up and eventually decides to put money into it. The higher a stock goes, the more buyers it attracts, and the more money they pour into it. Fear, on the other hand, often grips large numbers of investors simultaneously. When they all head for the exits at the same time, stocks sell off - that's why declines are always faster and steeper than advances.

Recent Historical Examples

The H1N1 pandemic was going to kill hundreds of millions, the Greek debt crisis was going to destroy the euro and break up the European Union, and Egypt was going to close the Suez Canal and deprive Europe and the world of oil supplies. Prior to that, the 2008 - 2009 greater than the Great Depression was the end of capitalism as we knew it; oil was going to $400 because we were running out of it...

If any of the above had really caused the devastation that was expected, the stock market would not have survived. But it has, coming back each time and powering higher despite dire predictions of doom and gloom. Clearly, it was investor fears that drove stocks down in each instance. But they were just that: fears. Investors sold because they feared an even bigger disaster coming, and when that disaster never materialized, the fear subsided and they bought back.

Investor Psychology

If you were told that stocks were going to decline 10 percent, would you sell? Probably not. Predictions are a dime a dozen, so you would have wanted some proof first. If stocks declined 5%, you would have probably thought it was normal; 8% - "I am down 8% already, stocks are expected to decline 10%, I am almost there so I might as well stay put." But if you were down 10% and stocks were expected to decline another 40%, you would have probably sold to prevent further declines.

That is how most investors think. They act now to avoid a bigger disaster later. So stocks decline when investors sell in expectation of a bigger disaster, not when the expected disaster hits. Once everyone who wanted to sell has done so, stocks stop declining. For example: When the U.S. was going to invade Iraq in 2002/2003,fears that Saddam Hussein would use weapons of mass destruction on our troops kept the stock market down but as soon as the military operations began, the market took off. Why? Because the worst fears never materialized, and there were no new fears at the time.

More from this contributor:

Correction: How Bad Will it Get?

Stock Trading: 10 Things to Do in a Correction

Stock Trading: How to Make 50% in a Correction with Little or No Risk