The Dunning-Kruger Effect and Managing FX Risk
This psychological prejudice where a person believes themselves to be better and more competent than they actually are, was first identified in Kruger and Dunning’s 1999 study “Unskilled and Unaware of It: How Difficulties in Recognizing One’s Own Incompetence Lead to Inflated Self-Assessments“.
To explain this in simple terms, I can use an example from a personal experience in January this year when I joined a skiing trip with a friend to Austria. This friend had never been to the mountains before, but had spent two hours at the Milton Keynes Snow dome and watched a few instructional videos, in addition to purchasing all the top brand skiing equipment. In his mind, he was 100% confident that he was going to be an expert. His actual experience and ability level was zero.
It will be no secret to those of you who ski that this overconfidence was premature. The first day consisted of him continually falling over on the baby slopes and moaning “my instructor is awful”, resulting in me taking over instruction. He was injured within 10 minutes of my ineffectual teachings and ended up with minor ligament damage. At this point he was ready to go home, but with a couple of days rest and reality setting in that good skiing requires a high level of competency, he hit the bottom of the Dunning-Kruger Effect curve with a total loss of confidence.
He humbled himself and got back to his lessons with an open mind. We ended the trip on a high note as he managed to get to the top of the mountain and ski down a long blue run – a major success after the first four days of no progress. This is a simplistic analogy of The Dunning-Kruger Effect, but one that still makes me laugh out loud!
So, how can The Dunning-Kruger Effect be applied in the Foreign Exchange market?
FX is one of those areas where it can be easy to gain confidence in your own skill, and quickly. Especially after a few timely trades and the market going ‘as you predicted’. It is a bit like investing, when I bought my first equity and it went up 16% in a day; I thought I was a genius.
In truth I had no advantage and many first-time retail investors may fall for the same costly illusion. Under FCA rules introduced in 2019, CFD trading websites now must show a disclaimer telling potential customers the percentage of their retail clients that make losses. IG Index displays 76%, whereas CMC Markets report 78%. These statistics show that the majority of retail investors will lose money by attempting to pick the direction of markets and this could serve as evidence that ‘beating the FX market’ is ultimately decided by luck, not skill.
What relevance does this have for managing currency risk?
Quite simply put, businesses with FX exposures could decide to treat the management of currency risk in the same way a retail investor might – either hoping for the best or having a ‘good run’ so that their confidence in the future direction of the FX rate outweighs any logical thoughts about planning for an unexpected scenario. By not having made provisions for the unexpected, particularly when the moves in FX rates go totally against their best guess and end up on the extreme side of volatility, businesses could be found in a precarious position.
These moves are often most pronounced during ‘Black Swan Events’. A Black Swan is an unpredictable event that is beyond expectations of a situation and has potentially severe consequences, in all markets and including currency markets.
In the past couple of decades, we have seen several events, including but not limited to:
- Black Swan Event 1997: Asian Financial Crisis
- Black Swan Event 2000: The Dot-Com Crash
- Black Swan Event 2001: 9/11
- Black Swan Event 2008: Global Financial Meltdown
- Black Swan Event 2009: European Sovereign Debt Crisis
- Black Swan Event 2011: Fukushima Nuclear Disaster
- Black Swan Event 2014: Crude Oil Crisis
- Black Swan Event 2015: Black Monday China
- Black Swan Event 2016: Brexit
- Black Swan Event 2020: Covid-19
Globally, the figures of businesses that use some form of hedging instrument to protect against currency risk, such as forward contracts or currency options, vary. In 2016, before Brexit, Bloomberg reported that only 25% of SME’s in the £5-20m turnover band used FX hedging instruments, leaving 75% of these businesses relying on the spot market. This meant that many companies with FX exposures in this bracket may have left underlying FX risks unmitigated and the subsequent financial performance of the business at the mercy of chance.
Infinity is here to bridge the knowledge gaps and help businesses to distill, understand and manage FX risks effectively. Nobody can predict the future moves in currency markets, but you can mitigate risk by reducing negative impacts that an adverse move may have on the business through effective planning.
There are a few clear messages from across our team, including our Head of Structured Products, Jamie Jemmeson and our Head of Corporate, Jock Chan:
- Nobody can accurately predict the future, so FX predictions used for forecasting models may not be appropriate to be used as a single reference point when developing an FX risk mitigation strategy
- FX mitigation strategies should be implemented as a measure to reduce the inherent risk to a business, not to try and ‘make money’ by speculating
- If you have an effective FX risk mitigation strategy in place, you may not feel so emotive about market moves knowing that you have taken steps to protect your business against these events
It is not uncommon that our services are requested at the bottom of The Dunning-Kruger Effect curve, when a business has ended up in a tight spot after failing to have effectively mitigated their FX exposure. At this point it is likely a decision between cutting your losses or taking further risks with the potential for the problem to become exponentially worse. It is important to build a risk management strategy and implement it long before FX becomes an issue.
For organisations of all sizes and at any point in the curve, Infinity has considerable experience in working with businesses to enable them to develop robust FX risk management strategies through our consultative approach.