Knowledge is power when trading stocks

Unless you have been living in a bubble, you would be aware that the Australian stock market has been falling over the past five weeks. In the last six trading days, it has fallen more than 6%, which has caused many investors to become fearful and act emotionally by selling stocks in the hope of trying to avoid further losses.

To understand why people do this, we need to look at behavioural finance, which explains why human emotions and cognitive biases influence our financial decision-making.

One of the most powerful emotions driving our financial behaviour is fear, which causes investors to panic and make irrational decisions like we are experiencing now. But acting irrationally in the stock market can negatively impact your returns.

In a bull market, investors tend to display behaviours such as a herd mentality and FOMO but when the market is bearish, they have a fight or flight response due to loss aversion.

While most investors know that reacting to our emotions is not the best strategy, unfortunately, most don't know how to change their behaviour. That's because overcoming fear is not easy, as it's hard wired into us and for good reason.

That said, overcoming fear is essential if you want to make rational decisions based on sound investment principles. There is a saying that 'knowledge is the enemy of fear' because if you know what to expect and how you will react prior to a situation occurring, you can make better decisions.

If investors knew that today would be the end of the fall and that over the next three months the market would rise 30%, I dare say that many, if not all, would not exit the market. Instead, they would take the opportunity to buy more shares.

While I'm not suggesting the market will do that, I need to emphasise that investors shouldn't be swayed by short-term market fluctuations, which is what I believe is occurring right now. Remember, the market fell more than 10% between August and October last year and more than 6% between December and January of this year.

As I often say, if you want to be successful in the stock market, it's important to gain the right knowledge, have a workable trading plan and trust the plan. This will help you to move through volatile times with confidence and, in the end, achieve better returns.

The best and worst performing sectors this week

The best-performing sectors include Healthcare, which is just in the green for the week, followed by Industrials and Communication Services, which are both in the red. The worst-performing sectors include Energy down more than 7% followed by Information Technology down more than 4% and Consumer Discretionary down more than 3%.

The best-performing stocks in the ASX top 100 include Newcrest Mining up more than 6% followed by Northern Star Resources up more than 5% and REA Group up more than 3%. The worst-performing stocks include Computershare down more than 14% followed by Pilbara Minerals down more than 10% and Challenger down more than 9%.

What's next for the Australian stock market

Regular readers know that I always say you need to wait for confirmation of a move rather than act on speculation and the All Ordinaries Index has certainly proven this statement to be correct in the past couple of weeks. Currently the market is down just more than 4% for the month and around 8% since the last high in early February. This week, the All Ordinaries Index has fallen to a low of 7100 points which is slightly below the lower end of my target zone for the low, which was between 7200 and 7500 points.

Obviously, there are two scenarios that can occur from here, and one is that the market stops falling and starts to rise again. For this to occur, I would expect it to start any day now and a strong close on Friday will strengthen my thinking around this.

The other scenario is that the fall will continue and while it's not the most preferable scenario, we do need to consider it. If the market does continue down, we need to expect the low will occur sometime in May and to fall below 7000 points and possibly as low as 6000 points.

One thing to be mindful of is that we can't control the market, we can only control what we do and how we react. We also need to understand that no one is 100% accurate in their analysis as to how the market will unfold, and as such, you need to put rules in place that allow you to manage both scenarios.

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