• Forex Market Philosophy

    Market Psychology versus an Efficient Market

    What seems like the most logical next step in the market progression is not always what happens.  True, a trader with a thumb on the pulse of the international scene will nail a few big trades each year.  But he or she will probably lose a far greater number of smaller trades.  Not only are these traders in tune with the international market, they are in tune with the psychology of traders across the globe.

    Market psychology is a carefully studied field in itself; I will not pretend to cover it in any sort of depth in this article.  However, I will give a broad interpretation of the subject so that those interested will have a basic understanding with which to start their research.

    The basic premise behind market psychology is that investors often act irrationally, which in turn affects the market itself.  Behavioral studies attempt to explain otherwise inexplicable glitches in the market.  Proponents of this theory contend that the supply and demand that constantly fluctuates prices is not entirely explained by fundamental and technical data.  Human emotions, judgment, and error are also major players in determining market price.  By having a firm understanding of the common actions investors take under given situations, and more importantly, how those actions affect market prices, one can invest defensively.  A defensive investor, by definition, is not as prone to the drastic losses that plague high-risk traders.

    In stark contrast to market psychology is the Efficient Market Hypothesis (EMH).  The EMH claims that market prices always reflect an accurate reflection of a particular item’s worth.  While still adhered to by a few traders, this concept has largely fallen out of favor.  Value traders are at the forefront of this assault on the EMH with their belief that a stock (remember, value traders stay away from trading currency) should only be bought when it is undervalued.  If the EMH were to be valid, this would mean that the long-term trader would never be able to enter the market!  Of course, the debate ranges much further than this, but the point is still clear: the EMH has severe problems.

    Another weakness, the EMH contends that over a long enough time period, the market is not something that can be beaten.  Modern investors largely discount this theory, mainly because of the examples investing superstars such as Warren Buffett have given us.  There are investors out there who continuously beat the market.  Maybe they don’t outperform their respective field every year, but they have proven that it is possible over the long run to do so.