While behavioral finance has been of interest since the 1970s, recent crises that have impacted the market (the 2008 subprime crisis, the Covid crisis, the Ukrainian crisis, etc.) have also shown us the extent to which the decision-making of economic actors can be affected by psychological factors.
And for good reason, mimetic behavior, cognitive biases and emotional reactions often lead to choices devoid of any rationality, ultimately resulting in very real financial losses.
Of course, the foreign exchange market is not spared from these shortcomings, and it is difficult (but not impossible) to become aware of them in order to correct the situation and protect both your budget and your margin. Treasurers and CFOs are as much victims of their own biases and emotions as they are of those of the other players in the market.
Let’s dive into the minds of decision makers to better identify and understand some irrational behaviors that are unfortunately all too often observed.
The proactive “heroes”
They are regularly at the top of the world box office, but also on the financial markets! The “superheroes”, these proactive economic actors, are often victims not only of an excess of optimism, but also of a control bias.
If optimism can be a strength when it comes to managing the smooth running of a company (it helps to move forward and to face failures), thinking of oneself as the MacGyver of foreign exchange risk management can prevent us from facing reality…
Indeed, when one has all the cards in hand regarding the choice of one’s hedging strategy (type of hedge, timing, budget…), the resulting feeling of control can lead to an exaggerated risk-taking; as well as a refusal to change strategy if it shows flaws or if macroeconomic parameters change.
Some players with this “hero” profile are also victims of poor quality information and reporting. In short, they are ill-equipped heroes who cannot direct all their goodwill in the right direction.
If control bias can hardly be countered in itself (we always tend to attribute our victories to our skills, and our failures to exceptional situations), it is better to be aware of it in order to limit its effects as much as possible and keep one’s rationality intact, as much as possible.
The following sheep
Another very powerful bias, which everyone has already heard about, is of course the herd effect, or mimicry. This is observed in many fields, including the financial markets, where the decisions of certain leading players generally (and very quickly) lead to identical movements by the mass of follower-players.
If such behavior allows us to follow the general trend, which is not necessarily a bad thing in the markets (Keynes said: “In finance, it is better to be wrong with everyone than right alone”), it often makes us react too late, when following the trend is no longer profitable.
Being aware of this “sheep” bias and the gap it can create between a wise decision and one made too late, it is better to take action at the first signs of a market reversal. It is therefore essential to have the appropriate monitoring tools to be informed in real time.
Passive traders
Finally, a third typical behavior found in the foreign exchange market is passivity. Some players simply suffer the economic ups and downs, or simply do not pay attention to them, and find themselves victims of two well-known biases.
The status quo bias, which consists in postponing an important decision for fear of making a mistake, and the confirmation bias, which implies remaining entirely focused on the parameters that go in our direction, closing our eyes to the signs of an unfavorable turnaround, lead to decisions that are disconnected from the real issues, and again too late.
Whether it was before the financial crisis of 2008, or before the recent geopolitical events in Ukraine, the warning signs were there, but the policy of burying one’s head in the sand once again prevailed, including in the economic world.
To avoid being passive and no longer a victim of the market’s vagaries, there is no need to rely on a crystal ball: it is better to be able to rely on good data monitoring and solid indicators. More than ever, managers at the top of companies must trust each other and rely on reliable information to defend their budgets and results.
Control bias, herd effect, confirmation bias… There is no doubt that economic actors regularly make decisions under the influence of their emotions, which can sometimes lead to major errors, and be sanctioned by substantial losses. While the markets are more aggressive than ever, it is necessary to be able to act quickly.
Today’s uncertain environment requires the rapid implementation of reliable and relevant strategies. To best protect your cash flow from currency and commodity fluctuations, don’t hesitate to use DeftHedge financial forecasting solutions!