Behavioral Finance: The Trader’s Psychology

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Behavioral Finance: The Trader’s Psychology

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Now, there is a branch of economics that is dedicated solely to the study of behavioral finance. This studies how the psychology of the actors of the financial markets contributes to the explanation of certain anomalies (price, returns). It allows us to go beyond the theoretical framework based only on the efficient market hypothesis and takes into account the psychology of the trader.

It is common to see financial crises in the aftermath of comments denouncing the “sheeplike” behavior of the investors. According to some critics, the bursting of the internet bubble typically illustrates the functioning of financial markets left in the hands of investors disconnected from the real world, and for whom “it is better to be wrong with all the others than to stand  alone.” A large part of financial crises can be explained by this phenomenon of a psychological nature alone.

While such comments may be exaggerated, it is important to understand that the functioning of financial markets is far from being based on purely rational and objective factors. Although a growing share of trade is now through complex algorithms handled by computers with vast capabilities (high frequency trading), investment decisions are largely based on humans. This is where the psychological factor comes into play (we obviously think of the issue of risk management methods) and it is here that we sometimes deviate significantly from the theoretical model of financial market evolution.

From micro behaviors related to individual psychology to the study of macro movements (bubbles), the work of behavioral finance will undoubtedly soon draw the psychological portrait of the trader. At the moment, this work is just beginning. Nevertheless, it is possible to draw inspiration from it to better understand the investment decisions of traders and to draw inspiration from them to act more effectively.

First of all, it must be understood that the approach adopted by behavioral finance is based on different types of reasoning, called cognitive biases. It is through taking these biases into account that we can improve trading. A simple example that will surely speak to beginners: faced with a loss, it is common to maintain their position according to the adage “not sold, not lost” in the hope of a future gain. Conversely, in a bull market, the tendency is to close quickly for fear of future loss. Such decisions are not based on rational choices. They can be detrimental to the development of a career as a trader.

Knowing them allows one to anticipate one's behavior and that of competitors in order to make decisions more effectively.

Cognitive and emotional biases, automatisms and self-fulfilling prophecies contribute to the march of financial markets. Understanding and integrating them is a definite comparative advantage for the trader.

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