The Importance of Rational Beliefs in Financial Trading

When a trader enters a trade, he is essentially acting out based on a belief. If a trader does not have a solid belief in a trade then entering a position is akin to gambling on a Las Vegas roulette table.

But where do beliefs come from? There are two general ways someone can adopt a belief; 1. They are told something by another individual or group of people, and they decide that this makes sense or makes them feel good so they believe it, regardless of evidence. 2. They observe from first-hand experience and then form rational conclusions about what is likely to happen in the future. Only the latter of these two belief-formation processes has any merit. Indeed, to believe in anything without evidence or reasoned observation is a fool’s game. If a supposed forex guru has sold you some bogus ‘strategy’ and you bought it simply because you believed him then you are almost certainly destined to fail. In trading, as in life, you advantage yourself by forming your beliefs based on science, observation, experience, and logic, rather than unsubstantiated stories. This practice, done over years and years, is how first-hand knowledge is gathered and experience developed, and this is essentially how you become a professional – at any craft or vocation.

In order to form high-conviction beliefs in trading you have to go back and observe what has happened in the past. For example, we can easily see that every time there is uncertainty in financial markets, the Japanese yen appreciates. This is because it’s a safe-haven currency (for reasons I’ll discuss in a future post) and this is a trade that you can have belief in, because the process has played out time and time again. The higher your conviction or belief in a trade, the better your results will be. And, as aforementioned, the only genuine way to form these beliefs is by experience and observation. Of course that’s not to say you shouldn’t take advice from more experienced traders and educators, but take everything with a pinch of salt until you see the market play out in the way they’ve described your own eyes.

In trading FX, the best way to attain high-conviction belief in your trades is to know – not guess – what the central bank is thinking. For medium to long-term fundamental trading, try not to look at the future currency direction through the eyes of the market, but rather through the eyes of the central bank. By reading and keeping up to date with the all the central bank communications, such as monetary policy statements, meeting minutes, press conferences and individual speeches, you will become fully aware of what aspects of the economy the central bank are focussing on and why, and also what their next move in monetary policy will likely be. Fundamental trading means not getting caught up in the ‘noise’ and irrational prices action, but rather having a strong, evidence-based belief in what the central bank is going to do next. The market is often wrong in terms of short-term price movements and these moments of mispricing can be capitalised on when you have a strong belief in how the central bank will respond to the unfolding economic outlook.

Nearly 500 years ago Galileo Galilei proposed, purely from observational learning, that the Earth revolves around the Sun and was not actually at the centre of the universe. At the time the entire world (read: market) disagreed with him, but they were wrong and he was right. He had conviction in his belief. A trader must do the same; have belief in the trade by observing what the central bank is focussing on. The market can be wrong, and you can be right. It happens to me all the time.

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