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Forex Markets: Behavioral Finance & the Psychology of Forex Trading

Hank Pruden, who formulated the theory of behavioral finance, says “For the better part of 30 years, the discipline of finance has been under the thrall of the random walk\cum efficient market hypothesis.

Forex Trading PsychologyYet enough anomalies piled up in recent years to crack the dominance of the random walk.” and goes on to add “Behavioral finance is the use of psychology, sociology and other behavioral theories to explain and predict financial markets. Behavioral finance describes the behavior of investors and money managers and their interaction in companies and securities markets.”

In other words, human weakness is consistent and predictable and that knowledge can help the forex trader to make money in forex trading. As we all know, the financial markets are dominated by a herd instinct where the dominant emotions are fear and greed. Investors stampede into markets out of greed and stampede out of them out of fear. So when we look at the four key indicators of volume, price, sentiment and time, we must necessarily look at the effect of human behavior.

Let us take a concrete example. When money first pours into the forex market on a buying surge, these are generally shrewd inve


storswho have read the signs and acted upon them. Later as volumes and prices build, the bandwagon starts to roll and the herd piles into the market. As the market starts to top, it is the herd that is doing the buying while the canny investor, having spotted the top, is actually doing the selling. Later, when the market corrects, as sooner or later it must, the smart investor has pocketed his profits and left losses to the herd.

Behavioral finance has its roots in Adam Smith (“The Theory of Moral Sentiments,”) and the two most important observations are:

-people often behave in an irrational fashion when making decisions and

-the way a decision is put to a person can influence that decision.

Markets can therefore be inefficient because the way people think and make decisions cannot be accurately expressed in mathematical terms. A lot of economic theory such as the efficient market hypothesis assumes that people act rationally and only after taking all the information into account. Actual evidence suggests,and forex brokers confirm, that contrary to this belief, a lot of decision-making in the financial markets would be considered arbitrary and irrational by classical economists.

The pioneers of behavioral finance found that contrary to utility theory, investors react to gains and losses differently. They fear losses far more than they like gains and will therefore take higher risks to avoid loss than they would to realize gains. The behavior known as “fear of regret” says that people tend to feel bad after they have been exposed in an error of judgment and often postpone selling investments that will result in a loss to avoid this regret. It is sometimes theorized that investors indulge in the herd mentality to avoid feeling regret if their judgment is wrong.

There is little doubt that behavioral finance brings an important extra human dimension to the analysis of forex markets. There is still some way to go in creating usable techniques for profiting from markets but a shrewd investor will certainly take human behavior into account while buying or selling. As William Gross said “Markets invariably move to undervalued and overvalued extremes because human nature falls victim to greed and/or fear.”

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