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The chapters of this book explore the psychology of the foreign exchange
market from a variety of perspectives. Some perspectives are theoretical;
others are practical. Some perspectives focus on individual decision makers,
others on how these decision makers interact to form collective market
processes, and yet other perspectives focus on the relationship of the players
that have traditionally been defined as ‘‘market participants’’ to their broader
environment, such as the financial news media. The variety of topics, stories,
and research results discussed portray the foreign exchange market as a deeply
psychological phenomenon.
Chapter 1, ‘‘From Rational Decision-Makers to a Psychology of the Foreign
Exchange Market,’’ compares the psychological and traditional economic
approaches to understanding financial markets. The traditional economic
approach postulates that all agents’ decisions are rational, that market prices
efficiently reflect all relevant information, and that market prices are always
consistent with ‘‘fundamentals.’’ The psychological approach stresses common
departures from perfect rationality that may permit informational inefficiencies
and may drive market prices away from fundamental values. The chapter also
highlights how the young discipline of behavioral finance has made important
strides toward integrating insights from cognitive psychology. However, a
comprehensive understanding of the foreign exchange market must incorporate
insights from a variety of psychological perspectives, including social and
personality psychology
Decision-making forms the center of a psychological understanding of the
foreign exchange market. Chapter 2, ‘‘Psychology of Trading Decisions,’’
discusses the social dynamics of herding, which permeates the market in
subtle ways and becomes especially prominent during financial crashes.
Because to traders feelings are the most important aspect of trading
decisions, the chapter also explains affective phenomena, such as trading overconfidence
and intuition next to so-called cognitive heuristics (i.e., psychological
rules of thumb traders use to accelerate trading decisions).
Chapter 3, ‘‘Risk-Taking in Trading Decisions,’’ explains the psychological
dynamics leading to asymmetric risk-taking and shows that so-called framing
phenomena may dramatically influence the risk-taking of market participants.
This chapter also discusses participants’ strategies to reduce biased risk-taking
in their trading decisions.
Chapter 4, ‘‘Expectations in the Foreign Exchange Market,’’ identifies expectations
as the key psychological link between market participants and
exchange rates. The chapter shows how forecasts based on technical
analysis, in contrast to purely fundamental analyses based on economic
theories, incorporate rudimentary market psychology. The chapter however
further shows that a complete understanding of expectations must also
consider subjective attitudes, social dynamics, and meta-expectations.
Chapter 5, ‘‘News and Rumors,’’ shows that participants in the foreign
exchange market do not occupy a separate world. This chapter examines the
various sources of market participants’ information and how important these
sources are to participants. It discusses the role of the financial news media, as
well as current trends in the reporting of financial news. The dynamics of
market rumors is explained partly through the interdependence between
traders and news providers.
Chapter 6, ‘‘Personality Psychology of Traders,’’ explores the importance of
individual personality characteristics to trading performance, showing that
certain traits promote profits and other measures of trading success.
Chapter 7, ‘‘Surfing the Market on Metaphors,’’ develops a novel understanding
of the foreign exchange market based on the experience of market
participants. This understanding questions the static concept of the market as a
machine implicit in economic theories. Instead, the chapter shows that participants
usually understand the market in terms of dynamic and organic
metaphors, such as ‘‘the market war’’ or ‘‘the market as a living being.’’
These metaphors have important implications for the behavior of participants
and the dynamics of the market.
Chapter 8, ‘‘The Foreign Exchange Market—A Psychological Construct,’’
synthesizes the earlier chapters to shed new light on the nature of the foreign
exchange market. Departing from the observation that human beliefs function
in part to reduce uncertainty, the chapter shows that theories of the foreign
exchange market are illusions rather than objective facts. These theories do not
address a permanent structure but rather a social and human construction in
constant change. Market participants need to adjust to the changing construction
of the market. Using the knowledge of the market’s psychology described
here, market participants may even shape the development of the market to
their advantage.
For readers less acquainted with financial markets and the technical aspects
of trading, Chapter 9, ‘‘The Basics,’’ introduces the main players in the foreign
exchange market and explains how they trade currencies.
The Appendix provides detailed information about the participants of the
two comprehensive research studies I conducted in the European and in the
North American foreign exchange market on which many of the findings
presented in the book are based.
Embarking on the journey of this book, readers will encounter some of the
theoretical and practical cornerstones on which the psychology of the foreign
exchange market builds. Along the journey, the book aims to be understandable
and engaging for the expert and the non-expert alike. For foreign
exchange professionals and private investors, the book dwells on the firsthand
experiences of actual market participants. For scholars in economics
and psychology who are interested in the psychological aspects of financial
markets, the book includes substantial new, rigorous evidence.
It is important to share two caveats. First, this book does not offer investment
advice. While the insights presented here will doubtless be useful to
traders, I do not spell out the connections from market understanding to
trading strategies. Second, the book is not encyclopedic. Given the vast
influence of psychology on individual behavior, the list of possible topics for
this book is very long. Inevitably, some psychological, economic, and financial
concepts will not be covered or will be dealt with only briefly. For further
information, the references provide a good guide to relevant original
research in both psychology and economics.
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