by Christopher Chen
Previous posts talked about understanding the foreign exchange market using a traditional economic model. These traditional models make sense under two critical assumptions. The first is that market participants are rational and the second is that financial markets are efficient. However, there is empirical evidence that market participants act in an irrational manner. For instance, traders can be biased toward a particular trading pattern or may not learn from past trading mistakes. And, financial markets are not truly efficient. For instance, individual market participants are unable to systematically outsmart the market and there should be no possibility for trading rules or strategies that systematically perform better than other strategies. Thus, understanding the psychology of foreign exchange traders and how their decisions affect the market is important.
Psychology Behind Trading Decisions
According to a survey of 321 foreign exchange traders, a majority of foreign exchange traders based their trading decision on their feelings of correctly anticipating the market’s psychology. The following are examples of the psychology behind trading decisions.
- Herding and psychological conformity: Herd behavior describes the phenomenon of how individuals in a group can act collectively without a centralized direction. In the foreign exchange market, herd behavior is when traders orient their own behavior according to perceived group norms. Thus, decisions then merely imitate the decision of others at the expense of other information. An example of herding is when a leading institutional bank such as Goldman Sachs issues a statement that the Australian dollar has to depreciate without any concrete rationale.
- Affects: Affects are the “feeling process” which is prevalent in the decision making process of investors. The following are examples of affects:
- Status quo tendency: The status quo tendency is the emotional bias that people prefer the current state of affairs. In the foreign exchange market, status quo tendency greatly affects the decision making of traders. For instance, a trader becomes too emotionally attached to a losing position and does not cut it. As a result, decisional escalations occur instead of just cutting losses.
- Overconfidence: Overconfidence is a bias in which a person’s subjective confidence in his or her judgments greatly influences their decision making. In the foreign exchange market, overconfidence occurs when traders make irrational decisions and disregard mechanisms to stop overconfidence trading such as stop losses.
- Heuristics (rule of thumb): Heuristics are informational shortcuts which people unintentionally use when making a decision. Often times, they can affect decision making. The following are common heuristics which are used by traders.
- Representative heuristic: A current situation may or may not be representative of past situations. Thus, people will often neglect the base-rate information and infer more than they should. An example of this is an investor may forecast future earning using a snapshot of current high earnings growth.
- Conjunction Fallacy: This faulty reasoning infers that two joined events are more likely to occur than either single event. Statistically speaking, either individual event occurring is more likely. An example of this is the stock market will go down and a certain currency will increase. One or both may be true, but there is a greater chance of only one being true.
- Availability: Availability refers to the idea that people judge an event based on situations that are psychologically relatable. For instance, foreign exchange trades from the United States may act in more of an aggressive way than their counterparts around the world whenever the Federal Reserve System raises or lowers its interest rates.
- Anchoring and adjusting: Anchoring and adjusting refers to the idea that people attach themselves to a value with psychological significance and arrive at a decision based on that anchor. In foreign exchange trading, a trader may have a particular bias for a news source and may base their decision on that particular news source.