In the recent equity market panic, I had a conversation with a friend, who is an equity analyst, where we were asking: what’s being discounted with prices being beaten down so much, when the fundamentals have not changed much from two weeks ago. The likely arguments were to imagine that either a) fundamentals were being mispriced or b) there is a change being reflected in the price, but the exact reasons are not yet known.

The two ideas work well for most cases. However, it helps to have a 3rd option: that participants can get “carried away” with sentiment, which then moves prices at usually disproportionate odds with the underlying factors. So prices have a tendency to overshoot, both on the positive (creating bubbles) and the negative (creating crashes). Either way, it keeps a trader grounded in reality to know that such a process does happen in the market, and keeps us from getting carried away ourselves. Ultimately it can save us a lot of money by filtering out investments/trades where sentiment skews the risks. Also it can help us in trades when we know sentiment is working in our favor. Really good stuff!