Okay it’s the name of this blog and a term we banter about but what do we mean? In short, we mean the power of an entire human psyche – intellect, thought, senses, feelings, emotions and energy. Each factor weighs in on the judgment, decisions and performance a trader (or investor) delivers and hence, elevating the whole (psychological capital) and leveraging the dimensions (thought, feeling etc) maximizes the performance a trader can deliver.

Underlying our zealotry for this topic is the reality that so much of our judgment and decisions is based on our senses, feelings and emotions despite society’s general reluctance to believe this. Neuroeconomics knows it. In fact the most highly respected neuroeconomists in the world say “it is not enough to know what one should do, one must feel it.” (Camerer, Lowenstein and Prelec, 2005).

Learning to read internal data – the ping pong between thought and feelings – helps one make better risk decisions. Understanding one’s emotions helps one make better investment decisions (Seo & Barrett,2007)…. so psych cap, simply put, is about using our brains (and psyches) in the way they are designed and to our fullest advantage.

Is there any good reason NOT to do this?

We didn’t believe it at first. We were amazed that traders transferred their deepest emotional architectures and echoes onto the prices… but alas, they do. In fact, it isn’t really all that surprising now that we know. I mean after all, the markets encompass and symbolize competition, winning, money, success and smarts. If you are going to have the echo of your deepest issues show up anywhere, why would it be somewhere with less stakes?

Which brings me to the question of Madoff…. last year at The Philoctetes Center (look it up? .org) he said that when he started his career everyone hated him for bringing electronics to the markets – and causing the human brokers to loose their jobs. So now at the end of his career everyone truly hates him again. And in between, he used charm and popularity to create this scenario.

This is how Freud’s Theory of The Repetition Compulsion works (see my paper published in Annals of Modern Psychoanalysis). My opinion? – this ain’t no accident and greed is a sorely insufficient explanation!

At this point I can only conjecture but my conjecture is that it was about the fear of missing out and the fear of being ostracized… the exact things he unconsciously created. This guy, for some reason, recreated being hated. This would leave the question of who hated him early on in his life open… but I for one would bet A WHOLE BUNCH on the idea that someone did.

It is horrid and shameful and everything else. There are a million things to say and that will be said…. but one of the lessons for traders and investors is – understand the emotional drivers behind market, investing and trading decisions. … whether it is you or your manager who is doing the trading …

to be continued. and… tell me I am crazy!

WSJ Weekend: “Fund Fraud Hits Big Names”. New York Times Sunday Business: Schiller talks confidence and beliefs and Ben Stein talks fear.

Madoff’s investors “felt confident” in his long-time consistent returns. Yet every article indicates there were multiple red flags. No investment fees? Not even a 1% management fee when most charge 2%? As Joe Aaron was quoted, “why would a good hedge fund guy work for pennies?” Conflicts of interest, no independent custodian, not even registered with the SEC before 2006 – why didn’t at least the other supposedly sophisticated hedge funds notice that stuff?

Because people want to believe. Read that again – want to believe. It means people have a feeling about having a feeling. Madoff’s spectacular Ponzi scheme only underscores what neuroeconomists are seeing in their pictures of our brains - that we base all our analysis (or lack thereof) and hence our decisions, on our feelings – no matter how much we want to believe (there is that word again) otherwise.

Famed economist Robert Schiller writes in today’s NY Times that if Obama could set a goal of full employment and if people would believe it, then confidence could be restored to the economy. I have met Bob. I like Bob. But.. Bob, c’mon – while you are technically and totally correct about the relationship between beliefs, the feeling of confidence and what people do, I seriously doubt any politician (even the almost-deity President-Elect) can inspire that kind of belief!

Nevertheless the real point is that the X factor here is the criticality of the physical experience (i.e. feeling) of confidence. …. feelings, feelings, feelings. Or take another New York Times columnist Ben Stein, “All that Fear” -? … “there is a new feeling in the land – fear – on a scale that I have never experienced. Chilling right to the bone fear. Fear that there is no bottom to our problems, that we got into this mess in some way we don’t understand, and that no one knows how to get out.”

“IN SOME WAY WE DON’T UNDERSTAND” - truer words have never been spoken! Underneath this entire great recession in the making is the problem that we don’t use our brains in the way they are designed. We simply don’t understand them – or at least most of us don’t.

We got into this mess because we all believe (there it goes again) in numbers and logic. We dismiss, discount and deny our feelings. Yet ironically if “they” had listened to the feeling of fear that the oddities about Madoff induced or the feelings of fear that Mathew Tannin of the Bear Stearns hedge funds wrote in his infamous email that has unfortunately earned him an indictment, we would not be where we are now.

NO! Skip the damn “maybe”. Us sophisticated financial types think that numbers, math and rational logic are the answer to everything. This belief couldn’t be further from the truth and it exactly what got us into this mess.

A group of the world’s leading neuroscientists, Camerer, Lowenstein and Prelec, call it Radical Neuroeconomics and it means that we can neither analyze, decide nor act without feeling. Invert that and it means that we do not analyze, decide nor act without feelings.

Therefore, it is always the feeling that counts – fear of the unknown matters now but while the bubble was blowing itself up, it was fear of missing out and fear of finding out your guy wasn’t making the 12%/year you were counting on.

In both cases, feeling the fear – analyzing and understanding it – would have saved you. It might possibly have saved Bear Stearns… and if BSC had been saved, then where would we be with Lehman, Citi, and the whole debacle of a credit crisis? it wouldn’t have felt good then but it sure would have been a lot less painful then what we have.

Let’s suppose anyone who was in on the chain two years ago – the group formerly known as investment banks, the ratings agencies, the mortgage brokers and yes even the home buyers had paid attention to that voice that was there. “Something about this doesn’t feel right.” Then let’s get really imaginative and suppose that the rest of the group would have accepted that kind of data…what might have happened? Would we have had one less risky loan, one more B- rating, maybe even an exchange for those weapons of mass financial destruction the CDO’s and CDS’s (exchanges keep things trading and it is the lack of trading that sent the credit market into the nosedive that our government is still trying to find a? parachute for).

FDR got it totally wrong. The only thing we have to fear is NO fear!

We just have to learn to systemically feel it, listen to it, understand and analyze it – just like we do with the numbers. Doing so would have saved billions – if not trillions – in worldwide market cap, global GDP and yes, ironically in the most important measure of all – that elusive X-factor confidence.

If you ask a neuroeconomist about the markets, they will say markets are NOT risky. In fact, they are 100% certain that risk is not the issue in markets.

What you say? Isn’t that the whole point – judging risk? Well yes… but, well actually no.

Let me explain. To a neuroecon type risk = known probabilities i.e. like in poker, chess or artificial experiments where you know there are 50 red balls and 50 green balls in a jar. In other words, if precise probabilities can be determined, it is risk.

If precise numerical probabilities can not be determined – the market – then it is uncertain or ambiguous and our brains react a whole lot differently. Knowing this is a huge mental edge.

Why? All of our methods for investing or trading – all of the tools we use to make decisions to buy or sell are only about approximating risk. This leaves us in the situation where we intellectually think we have determined precise probabilities but in fact, our unconscious brains knows that we have imprecision, we are missing variables and someone else might know more.

According to a series of studies, our brain then does a few things automatically – 1. It assumes a lower reward probability? 2. It handles the information using a higher level of feeling-based information.

In other words, if you really think about it, the way our brains interact with market data is a set-up to not follow our set-ups, trading or investing plan. Understanding this however can actually help -? through the awareness that a trading system is only an approximation designed to provide precise probabilities where none exist. In other words, we are fighting the architecture of our brains.

What tools can we use – developing an appreciation for psychological capital – which inherently includes our emotional foundation. The brain also tends to expect the same result from the next decision as you got from the last which is logical if you are just a brain trying to perform your job.

The conduit throughout all of this is what we sense, feel and emote – understanding that emotion and logic are two sides of the same coin and working within the brain’s design raises any one trader’s odds of extracting consistent profits from an inherently ambiguous system that operates on the fuels of hope, confidence and fear.

Sunday’s NYTimes included an article about the study done by John Coates at Cambridge – you know – the one that talked about hormones – particularly testosterone fueling male traders to take more risks and cortisol to show up when traders are losing money.

I don’t know about the experimental design as I am being an impatient trader and not actually going to the original but it seems intuitively reasonable.

So, the question becomes – as we wrote about awhile ago – what can anyone do about their hormones? I mean I don’t see the alpha males who are pursuing alpha returns taking estrogen shots or anything. (Well maybe some of them… there was after all that weird story about the manager at SAC capital but … I digress…)

On the other hand what do hormones do to us on a conscious level? They make us FEEL a certain way … right?

This means the window of opportunity lies in “feeling analytics” … Think of it this way, you can be purely self-absorbed because one of your best risk-management tools is an ever-increasing level of awareness regarding your own emotional state.

Feeling invincible? …. Call your younger brother and challenge him to a game of tennis.

Feeling infuriated? …. Get to the gym and punch that bag.

After you get used to keeping track of your psyche in this manner (after all if you are male and even some females, you were taught to do precisely the opposite)? – you will find that your percentage of profitable decisions goes up.

No hormone shots required.

… most of which are human.

I saw this in the NY Times… and here is says from the WSJ but in any event, the word is out. Math wizzes are human. The human brain does funny things with biases and predispositions that causes it to not see the data clearly.

In fact, one solution to this is to always assume that we are being biased and where the bias is and how can it hurt us? Where is the emotional attachment to the current “viewpoint” and how can that be a risk?

THAT is part of psych cap and the coming paradigm for comprehensive risk management.

On The Ubiquitous Missing Information in Markets: What Neuroeconomics Has to Say

‘Ambiguity’ is the Hallmark of Trading and Investing

The situation of taking a position when the odds are uncertain because of missing information is referred to by economists as “ambiguous”. F Knight in his book Risk, Uncertainty, and Profit was the first to emphasize ambiguity in 1921. Ambiguity (otherwise known as knightian uncertainty) is the hallmark of finance and should be acknowledged as such. To quote Nassim Taleb, the “rules of the game” are unknown in the financial arena.

What does this actually mean? Just that in many if not most trading and investment situations, the odds are not objectively known, and players may have little information and hence also little confidence regarding the true odds.

Offhand, such lack of confidence might seem counter intuitive: after all, observing relative frequencies should allow one to infer the underlying probabilities, don’t you think? Indeed, take a particular asset as being an urn from which you can draw a red or black ball where the red pays more but it isn’t known what the proportion of red to black is. After sampling the urn several times, one feels much more confident about its odds.

This is all nice in principle, but real world finance is far trickier and there are several reasons for our inability to confidently judge the probabilities in practice. True, we can observe the performance of a particular stock every period (be the relevant horizon one hour, one day, one month), and infer something about the stock’s odds.

But, these odds themselves change. Recent leading-edge econometrics literature has revealed unexpected jumps to affect stocks and bonds at an extremely high frequency.

In addition, a certain kind of probability is inherently subjective and cannot be inferred from observing relative frequencies: what about the chance of a landslide for Barack Obama on November 4th? Here the lack of information is irreducible and has to do with conflicting evidence.

Further, behavioral studies have shown that people feel they are missing information when betting against another person who is better informed. And even when there is no better informed opponent, people act as if there is.

To What Extent Does This Matter?

For all these reasons, taking a position is not a decision about known odds but a decision with ambiguous information.

Why does this matter? Because choice depends on how much relevant information is missing or how ignorant people feel compared to others, as Chip Heath and Amos Tversky first pointed to in a beautiful paper (1991).

Mr. Spock Does Not Care about Ambiguity…

At first glance we may assume the reverse, that is that traders and investors won’t act differently in the face of risk and ambiguity. Indeed, standard economics invites us to do so, because expected utility theory totally ignores the importance of confidence in judged probabilities. Its bosom stance is that the probabilities of outcomes should influence choice, whereas confidence about the probabilities is irrelevant. The proof is very clean and ushers in a misleading view of decision-making under uncertainty.

Here is the logic of expected utility theory. (Readers who don’t like Mr. Spock can skip this bit without any damage — homo economicus being characterized by Mr. Spock is due to Richard Thaler.)

Suppose two assets, a risky one, which will deliver 100 dollars or 0 with equal probability, and an ambiguous one, which will deliver 100 dollars if Mr. Obama wins the election, and 0 otherwise.

Do you prefer to invest in the risky asset or the ambiguous one? Now consider a symmetric ambiguous asset which will deliver 100 dollars if Mr. Obama loses and 0 otherwise. Again, ask yourself whether you prefer to invest in the risky asset or this ambiguous one.

Choice consistency leads to choose the ambiguous asset in the second case if you have preferred the risky asset in the first case. Why? Because for expected utility theory, choosing the risky asset in the first instance reveals your probability that Mr. Obama will win the election to be smaller than 1/2. Therefore, you should prefer the ambiguous asset in the second case, since for you the probability that Mr. Obama will lose is higher than 1/2.

… But Human Beings Do

By ignoring the influence of confidence in choice, expected utility theory is missing a key point. Most of us will invest in the risky asset in both instances. This is Ellsberg paradox, first revealed by Ellsberg in his paper “Risk, Ambiguity, and the Savage Axioms” (the “Quarterly Journal of Economics”, 1961).

Actually, the premise that confidence about the probabilities is irrelevant is wrong on both the behavioral and the neural level. Under ambiguity, the brain is alerted to the fact that critical information is missing and that the ensuing uninformed choice therefore is more potentially dangerous.

A milestone study by Ming Hsu and colleagues, published in “Science” in 2005, has revealed the level of ambiguity (when choosing between a risky bet and an ambiguous one) to be positively correlated with activation in the brain areas known as the amygdala and the orbitofrontal cortex, and to be negatively correlated with activation in the caudate nucleus within the striatum, well known to be implicated in reward prediction.

An Evaluation System in the Brain that is Sensitive to the Levels of Uncertainty

Further, in their study, activity in the caudate built more slowly than activity in the amygdala and the orbitofrontal cortex. This is strong evidence for the existence of two connected systems. Upstream, a vigilance system sensitive to the level of uncertainty in the context (the OFC / amygdala complex), signals uncertainty to the anticipatory reward system downstream (the striatum). In other terms, the OFC and the amygdala evaluate uncertainty and modulate the expected reward signal in the striatum. Interestingly, in the same study, the authors further demonstrated that OFC-damaged subjects do not distinguish between the risky bet and the ambiguous bet, thereby acting in a way that is consistent with expected utility!

Inhibition of Impulsiveness when Facing Ambiguity

Further study by Scott Huettel and colleagues at Duke University, has confirmed that specialized neural mechanisms are involved under ambiguity and that they are well dissociated from those implicated in risky situations. Interestingly, this study — published in “Neuron” in 2006 — links the inferior frontal sulcus, within the lateral prefrontal cortex, to decision-making under ambiguity. This is interesting to more than one extent. First, this region — and others around — has been shown by Etienne Koechlin and colleagues, in a study published in “Science” in 2003, to be crucial for contextual control, when one needs to resolve the multiplicity of possible scenarios to set one’s own rule for behavior.

Remember Taleb: in finance the rules of the game are typically unknown, so we have to construct them…

Further, in the same study, Huettel and colleagues have found that the ambiguity effect in the inferior frontal sulcus is less pronounced in those subjects with a higher degree of cognitive impulsiveness — as measured by the BIS impulsivity scale. Although this is purely correlational, it is tempting to conjecture that the inferior frontal sulcus plays a role in inhibiting impulsiveness here, presumably by sending an alerting signal — pointing to a lack of confidence — to the striatum downstream.

So What?

Acknowledging the prevalence of ambiguity aversion in finance has already had far-reaching implications. For instance, ambiguity aversion might explain the well-known home-bias in investing, as well as the equity premium puzzle – this route to explain the equity premium puzzle has been explored by Larry Epstein.

We would argue that outside academia as well, traders and investors should pay special attention to the underpinnings of their behavior when deciding under knightian uncertainty.

Robert Shiller writes in the New York Times about the role of group-think during the upward phase of our blown-up housing bubble. He recounts the polite discounting of his warnings in Irrational Exuberance (see all of Shiller’s books) and says “speculative bubbles are caused by contagious excitement.”

He segues to the remaining gap between economics and psychology in a discussion about his experiences as a predictor of catastrophe. In doing so, he coincidentally supports the neuroeconomics research in a new paper by Drs. Camelia Kuhnen and Brian Knutson – The Influence of Affect on Beliefs, Preferences and Financial Decisions – “beliefs are updated in a way that is consistent with the self-preservation motive of maintaining positive affect and avoiding negative affect, by not fully taking into account new information that is at odds with the individuals’ prior choices.”

Translated into trader’s English their point is that we tend not to pay much attention to information that would suggest we are wrong about something. In other words, we are less than open-minded (politics anyone?) because if we find out we are wrong, we might have to feel badly about ourselves and that is simply no fun.

Shiller mentions this exact kind of thing when he says “Economists…pride themselves on being rational. … The notion that people are making huge errors in judgment is not appealing.”

To my way of thinking – “not appealing” = doesn’t feel so good = “avoiding negative affect”.

Let’s make sure we have this straight. We don’t want to feel badly about ourselves so we “overlook” data that could actually lead us to a better decision?

Feeling “bad” for a bit could prevent us from making decisions that are going to make us feel far worse somewhere down the line. Put another way, we prefer to feel better now even if we risk feeling really bad later.

Economists like to believe we are rational. Behavioral economists noticed we are not. Neuroeconomists can show us our brains firing on emotion before logic and Andrew Lo of MIT says logic and emotion are two sides of the same coin.

What this means is that we need to learn how to tolerate feeling bad – usually for just a little bit. At first you have to think of it as the tedious research phase of an important project. (It does get easier with practice.)

“Negative affect” has protective value in it. The feelings we don’t want to have are actually on our side…and learning not only to be able to feel them but to inquire about their message can’t help but produce better decisions from those flip sides of the coin.

And that skill is a significant part of what we call having PSYCHOLOGICAL CAPITAL.

The NY Times esteemed Op-ed and they leave out the best part – as mentioned in our earlier post today.

It is all fine and well to notice that we behave irrationally, it is all fine and well to say that some things are Black Swans… what it is NOT fine and well is to ignore the reality of what we now know about decisions… ala our earlier post repeating Dr. Andrew Lo’s message.

As soon as anyone/everyone realizes that we can’t do anything without a feeling, that all decisions have an emotional-basis and that “emotion analytics” are the #1 clue to figuring out what is risky and what is not… or at least what is best… the better off we will all be.

…and besides… one you factor in “affect”, those Black Swans miracously start turning white!

” Lo went on to say that research in the past decade shows that rationality and emotion are not as dichotomous as we might assume.? In fact, he says that we need to be able to feel emotion in order to be ?logical?.? In other words, emotion and logic are two sides of the same coin.? Medical research reveals that brain-injured individuals lack the ability to use heuristics to navigate the complexity of daily life.? Doctors say that these patients spend inordinate amounts of time on minute tasks like picking fonts for a Word document, or picking what to wear in the morning.”

Hey he is a Ph.D at MIT and I am only a mere M.A. from Chicago….so, don’t believe me, but do believe Dr. Andrew Lo. (just ask us if you need help learning how to use the insight ; /)

Check out the whole report at BOSTON REPORT – All About Alpha. Com