Introduction.
As an element of the modern global economy, data and analytics can be deemed as the holy grail of financial decision-making. The basic instruments of a market analyst are charts, technical indicators and historical models. But our recent years have proved that the data does not quite work accurately to predict how the markets will behave. What causes irrational reactions of markets? What is the reason behind the fluctuations on the price even in the absence data reports?
Human behavior is a common reply to the question. This is here behavioural economics comes in as an effective spectacle that investigates the impact of psychological, cognitive and emotional factors in the market. It would also be important to the SMEs operating through the turbulent currency markets to incorporate the concept of behavioural insights to the conventional market analysis because this makes the difference between the speculative risk and the strategic action that would be based on a well thought.
What is behavioural economics – and why it matters.
Behavioural economics is the science which deals with psychology of money-related choices. Behavioural economics appreciates the fact that people are swayed by emotions, biases and heuristics more often than not in the real world unlike the classical economic theory, which views people as being rational and logical.
This is especially the case in the currency markets where the forces of uncertainty, speculation and news-fuelled sentiment may dominate over economic fundamentals. The repercussions are massive to the businesses involved in international transactions: ability to know how people respond to the variables of the market condition enables making smarter and more adaptably designed FX planning.
The Limitations of the Classic Analysis of the Market.
There are two common tools of standard market analysis, i.e., the fundamental (economic indicators, interest rates, GDP, etc.) and technical (charts, price patterns, moving averages) analysis. At the same time as they are the same, they tend to lose touch with the question of why the prices move.
For example: After a positive jobs report a currency can weaken due to the fact that the results were not being considered to be good enough by investors.
In cases of a central bank decision, the decision may be even sold before it is announced thus causing counterintuitive movements.
All these scenarios emphasize the importance of the knowledge of the expectations, mood and perception of investors that fall in the scope of behavioural market analysis.
The important ideas of how emotions drive markets.
This is a list of the key concepts of behavioural economics applied to FX and possible market behaviour:
–Loss Aversion: Human beings experience loss averseness more than they enjoy the pleasure of gains. This may result to panic selling or reluctance to hedging currencies at the appropriate time.
–Herd Behaviour: when faced with uncertainty, investors and businesses become herds that copy others. This brings about self-reinforcing trends-bubbles.
– Anchoring: A decision-maker sticks to a given frame of reference and uses this old rate of exchange to give skewed decisions.
– Overconfidence: Most companies think that they are able to forecast FX more than it is possible, and that results into them being unprepared.
Case study: The British Pound and Brexit.
Examples include the behaviour of GBP in the course of 2016 Brexit referendum. Even though there were obvious dangers, numerous companies did not engage themselves in hedging.After the vote, GBP fell by more than 10 percent against the USD in an overnight trading. Why were the people do asleep?
Conventional analysis gave conflicting messages, but behavioural signals were pointing at something more worrying: as people started searching online more about the consequences of an economic stimulus, social media anxiety levels increased, and the options markets started getting volatile: fear was rising.
Companies, which integrated the behavioural indicators and technical information had more chances to hedge early and lessen exposure. It is one of the well-known examples when psychology provided answers even before the figures could.
What makes KeyFX useful.
In our KeyFX site we realize that markets are not mechanistic systems, but they are human systems. This is the reason as to why we are investing in the devices that integrate behavioural insights with data-driven analytics.
In our market intelligence reports we are progressively adding more:
–Social media and financial news based market sentiment summaries.
–Behavioural trend signs– Signals which show FX trends that are crowd-induced
–Contextual dashboards which treat numbers and investor psychology.
They allow SMEs to conceive a competitive advantage in knowing how sentiment will drive prices in the short run—not what rates will change and where, but more importantly, what the average reaction to the same might manipulate.
Practical tips to SMEs.
Behavioural economics is not the epitome of economists but rather a guide to various SMEs when it comes to international finance.
These are the ways small and mid-sized businesses can integrate these lessons:
1. Do not measure only numbers but measure feelings. Google trends, financial Twitter sentiment, or the market briefings by KeyFX are the tools that will help you know how people are feeling.
2. Tens rules to minimise the rise of emotional decision-making. Pre-set hedging strategies are the way to prevent panic.
3. Jerk your presuppositions around. Do not expect that a past exchange rate would come back, that is anchoring.
4. Analyse the decisions made in the past. Did you make it with data or fear/hope?
5. Utilise third party affiliates. Collaborate with FX experts such as KeyFX that give behind the price chart context.
Case in point: The travel industry Behavioural Traps.
A UK based travel company had not purchased EUR to make a summer booking in the hope that GBP will pick up. The overconfidence and anchoring were the reasons behind their choice to forego the negative sentiment brought about by political uncertainty. This forced them to purchase the currency at a lower rate a couple of weeks soon.
They would have caught better rates early except that had they been using behavioural tools to measure mood, they would have observed that there was rising anxiety in the market. Fear is not the issue of behavioural awareness, rather it is being realistic.
Propensity to Behave in the Tech Seek.
Technology is prone to be hit with too much optimism or pessimism- otherwise referred to as hype cycles. Such psychological cycles affect all kinds of stocks, as well as the currency exposure of SMEs operating in the technology sector and dealing with the software licensing business, cloud systems, or online advertising and marketing.
There is an example of a European software company venturing in Latin America. The headline about a change of regulation in the region was received with panic by the investor communities on forums and news domains. The euro also devalued against some of the Latin American currencies even though macro economic conditions were stable.
A business which was purely depending on the economic reports would have misinterpreted the time. However, had the firm kept an eye on behavioural indicators like stepped up internet conversation, LinkedIn commentary and an upsurge in the use of keywords, it would have anticipated sentiment-related volatility and hedged its currency risk ahead of it.
Behavioural Market Indices.
Behavioural Market Indices can be defined as offering markets measuring the life and it can be utilised by the consumers to obtain the number of facts they are not able to get. This is when the Understanding Behavioural Market Indices is taken into consideration. Nowadays sentiment can be measured through a number of behavioural indices which are provided through many financial platforms.
For instance:
Fear and Greed Index: Index based on emotion which is measured based on volatility, volume and momentum of the traders.
Volatility Index (VIX): Indicators that measure the market expectation on the short-term volatility.
Commitment of traders (COT) reports: report the positioning of institutional players.
Raw data might not be important in SMEs to analyse on a daily basis but conformation of spikes or extreme readings can help put things into perspectives. At KeyFX we are working on tailor-made dashboards that convert this data into real life simple-to-read indicators. It makes businesses respond, and not react.
Short to medium-Term Exchange Rate polices with Behavioural Data.
Although the short-term trading can be said to be the most common trading lingo when it comes to FX, SMEs tend to have a cash flow projection of 3-6 months.
The important part of this is behavioural data:
-Prepare in advance when the sentiment is too optimistic – that is one of the red flags hinting at a correction.
-Apply forward contracts at the highest point of the times when fear sets in: this is also a time of mispricing.
-Limit exposure to the herd-driven markets by diversifying the market.
It is not all about prediction, behavioural insights are all about preparation. And provision makes an individual less susceptible to finances.
Final Thoughts.
As SMEs find themselves in the middle of the noise, data, and uncertainty bombarded marketplace, the technical knowledge is not enough; they require the large-scale effective use of the emotional intelligence. That advantage is provided by Behavioural economics.
It assists the business leaders:
-Become crisis ready.
-Time currency runs with a better understanding of it.
-To Know market Psychology, and not market mechanics.
Are you ready to make the FX shift, being reactive to proactive?
For more FX insights and expert updates, check out our latest posts here.
