Market Psychology And Behavioral Finance

Finance and psychology have enjoyed a relationship for a long time. Though the effect if psychology has lessened over the years, it still has a power over economics. Psychology is based on human behavior and how it affects the market. In fact, it wouldn’t be wrong to say that the positive and negative trends of the market depend upon the decisions make by humans. And this is the reason, why Hank Pruden called this science “Behavioral Finance”.

Human nature is predictable and predicting this can help the trader earn profits in Forex trading. What it means is that the market is governed by two strong emotions – greed and fear. Traders enter the market because of their greed to earn profits and only those with no fear are left in the end. 

The Theory Of Moral Sentiments makes two observations regarding market psychology. The first observation is that people do not make any decisions rationally and the second observation is that this decision is dependent upon the decision that was put earlier. These two observations clearly indicate how human decisions affect the market and are responsible for its inefficiency.

Take, for example, the effect of human behavior on time, volume, emotions and money. The influx of money into the market is due to traders who are on a buying trip on account of their having read signals correctly. As their signals prove to the correct, the prices increase and more and more people begin investing. When the market reaches a crescendo, the initial traders begin to sell anticipating that having reached the peak, the markets will now take a downward trend. They have therefore, put their knowledge of market psychology to good use and earned a profit.

While it is commonly believed that people take financial decisions after taking all aspects and information available into account but it is not true. Most of the decisions taken have no rationality. The reaction of people to profits and losses is varied but almost all of them have one reaction in common and that is the fear of losses and love for gains. But not many will take high risks to earn profits.

This fear of losses has been termed as “Fear of regret”. It means that when people make errors in decisions and suffer losses, they fear to sell investments at the right time, suffering more losses.

When the market is analyzed, human nature is also taken into consideration. Though, there is no way to judge how people are going to think and react in the next moment, there are shrewd forex traders who can correctly gauge them and make a tidy profit.