What is behavioral finance theory (behavioral economics)?
Behavioral finance theory is an economic theory based on the premise that people do not always act on the basis of rational decisions due to psychological and emotional factors.
Prospect theory by Dr. Daniel Kahneman won the Nobel Prize in Economics in 2002, and this led to an increase in attention, and behavioral finance theory quickly became a major school of economics.
Until then, economists had always studied economics based on the assumption that people make rational judgments and choices, and behavioral finance theory had a major impact because it overturned this assumption.
However, if you think about it, it is common sense based on life experience that people are irrational in the everyday sense.
So, it may be said that economics has finally come closer to the realities of human nature.
Looking back on my own trading, it may come to mind with some heartache that not all forex traders are rational beings and tend to choose irrational or irrational behavior.
That is why understanding behavioral finance theory (prospect theory) and applying it to your daily trading is an important initiative in terms of trading profit/loss and mental stability.
Related FXで問題のあるトレードスタイルの解説まとめ
Reference link to “Behavioral Finance Theory” (in Japanese)
Reference 基礎から学べる「行動ファイナンス」 第1回―合理性と心理バイアス―
What is the “sunk cost effect”?
Sunk cost is an economic term that refers to costs (time, money, and effort) that have already been invested and cannot be recovered.
Rationally speaking, the amount of money already paid and the time and effort already invested cannot be recovered in any way, so they should be disregarded as sunk costs and judged on a zero basis.
In reality, however, we psychologically cannot ignore them and tend to make decisions based on the sunk costs as a comparison, which is called the sunk cost effect (Concorde effect).
As an example, if a movie is boring after paying the admission fee, it is considered a rational decision to leave the theater and spend the two hours for something else meaningful.
However, many people tend to choose to continue watching because they want to get their money’s worth or because they do not want to waste the effort of coming to the movie theater.
What is the “Concorde Effect”?
The Concorde effect refers to the psychological state of being unable to stop investing because of the inability to make objective decisions.
This is what is referred to as sunk cost in economics: the feeling that if one stops investing, all the money invested so far will be wasted, making it impossible to make the choice to stop in the middle of an investment.
Objectively speaking, if the current situation is not producing results or losses are increasing, further investment of money will only increase the losses.
By stopping that investment as soon as possible, you should be able to stop unnecessary negative losses in the future.
However, since the money already invested seems to be a “savings or reserve fund,” there is a great psychological resistance to giving it up.
This is a fallacy because it is not really savings or reserves, but money that has already been spent and lost.
Unrealized losses further cloud judgment
Unrealized losses in foreign exchange trading (FX) are losses that have not yet been confirmed, so it can be said that they can make objective judgments even more erratic.
This is because there is no doubt that there is a possibility that the price will return to the quoted price, and there is also a possibility of unrealized profit.
However, if the prearranged trade plan determines that there is “no chance,” it is best to cut your losses as soon as possible, fix the actual losses, free up your margin, and move on to the next trade.
To continue to maintain an unrealized loss position against the rules is an opportunity loss (in time and money) for the future.
What is mental accounting?
Mental accounting is the irrational tendency to make decisions about money.
It was proposed by behavioral economist and Nobel Prize winner Richard Saylor.
Mental means “psychological” and accounting means “individual wallets (accounts),” which directly translates to “having multiple wallets in your mind.
It refers to the tendency to create multiple wallets in one’s mind, instead of viewing one’s money as a whole, and to judge gain or loss by each wallet, resulting in irrational choices and decisions”.
Specific examples of mental accounting
Examples include the following.
- When you have a wallet full of $100 bills, you waste money and regret it later.
- When you buy a new car, you feel that “$2,000 for the optional navigation system” is cheap.
- When you win money by gambling, you spend it as if it were money that just fell into your lap.
- The money they saved up from their part-time jobs is too good to spend.
In this way, we psychologically weight money differently depending on how it came into our possession and what we intend to do with it, and as a result, we treat it as if it has a different value, even though it is the same money overall.
Specific examples of mental accounting in forex trading
An example directly related to a forex trade is as follows.
- Since I won the last trade, I thought, “If I lose the next one, it won’t be a loss,” and so this trade was a messy entry in terms of rule compliance.
- I got scared because I lost the last trade and did not want to reduce my margin, so I entered a smaller position than planned in this trade.
Although all of these are the same FX account funds (margin), they are irrational decisions as a result of being psychologically dragged down by the last minute increase or decrease in funds (how they gained or lost).
It is a very irrational act to say “I don’t care if I lose the money I won,” disregarding the fact that I took the risk to increase the margin in my FX account.
However, mental accounting is a psychological tendency that can easily lead to this kind of decision.
Becoming more aware of mental accounting in both your daily life and trading is one of the factors that will bring you closer to success in forex trading.
What is the “Harding Phenomenon”?
The Harding phenomenon is the tendency of the crowd mentality to feel secure by behaving in the same way as a large number of others.
A simple example of this is the psychological state of “crossing a red light together is not scary.
Even if a group of people are acting in an irrational manner, it is difficult for one person in the group to act rationally.
Rather, it is human beings who feel more comfortable when they behave in the same way as the group.
This tendency leads to the recurrence of crowd behavior in the market, which cannot be considered very rational.
A typical example is the bubble market.
Rationally, we know that one day someone will pull the trigger, and that will trigger a major adjustment or trend reversal.
However, when you are in the middle of such a market, you think, “Everyone else is buying and making money, so I must buy too or I will lose money,” and you feel that trading in this way is the right and safe thing to do.
This herd mentality sometimes causes unreasonable price movements in the market.
Related FXで問題のあるトレードスタイルの解説まとめ
That is all I have to say about behavioral finance theory and FX psychological biases in this article.
