Knowing the Risks: Theory and Practice in Financial Market Trading

TLDR

Financial market trading theories are well developed and influential, yet trader behavior often deviates from theoretical predictions, and general theories about risk‑return relationships coexist with instrumental behavioural rules that require belief in both theory validity and individual agency. The study aims to document the paradox between trader behavior and theory and assess its implications. The authors use data from a study of traders in London to investigate this paradox.

Abstract

Theories about trading in financial markets are well developed and practically influential. However, traders’ behaviour within these markets appears to deviate substantially from that predicted by theory. Using data from a study of traders within financial markets in London, this article seeks to document this apparent paradox and assess its implications. General theories about how the financial world works are distinct from, but compatible with, more instrumental behavioural rules about how to work in the financial world. The latter may be seen as internally consistent recipes for action which require concurrent belief in both the validity of the general theories - for example about the relationship between risk and return - and in the ability of individual agency to secure outcomes which, in terms of the general theory, have low probability.