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Do Psychological Fallacies Influence Trading in Financial Markets? Evidence from the Foreign Exchange Market

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  • Michael Bleaney
  • Spiros Bougheas
  • Zhiyong Li

Abstract

Research in both economics and psychology suggests that when agents predict the next value of a random series they frequently exhibit two types of biases, which are called the gambler's fallacy (GF) and the hot hand fallacy (HHF). The GF is to expect a negative correlation in a process that is in fact random. The HHF is more or less the opposite of this—to believe that another heads is more likely after a run of heads. The evidence for these fallacies comes largely from situations where they are not punished (lotteries, casinos, and laboratory experiments with random returns). In many real-world situations, such as in financial markets, succumbing to fallacies is costly, which gives an incentive to overcome them. The present study is based on high-frequency data from a market maker in the foreign exchange market. Trading behavior is only partly explained by the rational exploitation of past patterns in the data. There is also evidence of the GF: a tendency to sell the dollar after it has risen persistently or strongly.

Suggested Citation

  • Michael Bleaney & Spiros Bougheas & Zhiyong Li, 2017. "Do Psychological Fallacies Influence Trading in Financial Markets? Evidence from the Foreign Exchange Market," Journal of Behavioral Finance, Taylor & Francis Journals, vol. 18(3), pages 344-357, July.
    • Handle: RePEc:taf:hbhfxx:v:18:y:2017:i:3:p:344-357
    DOI: 10.1080/15427560.2017.1331234
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    1. Matthew Rabin & Dimitri Vayanos, 2010. "The Gambler's and Hot-Hand Fallacies: Theory and Applications," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 77(2), pages 730-778.
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