” 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

The unexamined truism, old wives tale advice …

from a CNBC guest blog …scroll down the the part where it says this -”2. These are trading markets where the ability to execute without emotion is the key to success.”

I realize that neuroeconomics is a new field and that the word hasn’t gotten out yet but all facts of today’s latest science points to one of those truths we all know if we just stop and think. No human does anything without at least some emotion. We don’t get a glass of water without WANTING one and what is “wanting”?

In fact Seo and Barrett’s 2007 study showed that indeed being emotional and knowing it created the best investment performances out of a group of 20 active investors (traders) over a 100 day period.

Most of the problem lies in the reality that most traders and investors spend so much time trying NOT to be emotional that they lose the focus, insight and wisdom their emotions can provide…

And remember that emotion is a feeling – much like gut instinct is a feeling. Even when we choose variables for a quantitative model of investing (theoretically the most rational one) we do so with some feeling about why those variables are best.

Forgive me for the rant but in these markets, where clearly the feelings of fear interact with the fundamentals to create NEW fundamentals and new fear… the professional investing and trading community (even if no one else) desperately needs to understand the reality of how the human brain evaluates, decides and acts.

Attempting to do so without emotion only asks us humans to turn into computers and

1) it isn’t going to happen.

2) it is about the quickest way to send an emotion under-ground and into direct action via a hasty buy or sell that is later a source of regret… particularly on the advice of an expert (neuroeconomic reality).

What do our brains do when a down-trend becomes an avalanche – when
some snow gets rolling at the top and picks up steam and snow and speed
until it hits bottom – with no regard for anything in its way?

Two things to know -

First, it tends to assume it will get the same result from the next
event as it got from the last event. In market terms, this means that
looking at losses predisposes all of us to expect more losses – the
timeframe is basically irrelevant – at least as far as the brain is
concerned.

Neuroeconomics research also indicates that the emotion resulting
from a “first” event also colors any? analysis of the next event -
without us knowing it and before we are conscious of what is happening.

Put the two together in today’s market and the third fact that fear
can easily spread from one person to the next and presto, feelings of
worry turn to fear turn to panic and then morph into limit down.

Interwoven into these human psychological realities, facts like
deleveraging (otherwise known as margin calls) force additional selling
which exacerbates the selling and creates more of the brain’s above
decision cycle.

This is where we are today and the “engineering” behind how the
markets tend to extract the most money out of most of the people.

The opportunity lies in interrupting YOUR brain from taking this trip.

The way to do that is to use what we call EMOTION ANALYTICS.
Researching and dissecting whatever feelings and expectations wash over
you – versus just taking action – gives anyone who tries it a window.
Windows give you the ability to see a more accurate picture to predict
what is really likely to happen next!

The WSJ’s Intelligent Investor …

The weekend edition of the WSJ included Zweig’s column on fighting the herd mentality. In many ways it is good article… but it does what all articles and commentary seem to do… in the end it says “get rational”. The problem with this is when you feel terrified it is extremely hard to use your analytical mind to overcome that.

The trick is the counter-intuitive and ironic one of allowing yourself to feel what you feel.

Just remember that feeling afraid doesn’t dictate you take an action. If you listen to the panic it will actually allow you to think more clearly as the act of listening alone will calm what your psyche is doing to you.

I know it goes against conventional wisdom but let me ask you to try it. Try it with anything – something that makes you feel a little nervous. See what happens when you say “Okay Denise you are really nervous about…..”

… just sit there for a few minutes (or longer) and explore the feeling inside of you. Ask where it is coming from. You will find that using this approach is the fastest and most effective way to induce a greater sense of calm as you will realize that you are most likely unconsciously imagining total disaster and chances are that is not really the situation. Once you realize that, you have automatically got a more reasoned perspective on whatever is inducing the panic – public speaking or plunging markets.

and oh btw, this fits with what we know about emotions firing before thought… “anticipatory affect” is what they call it in the labs. Learning to use this tendency of the brain can be to your great advantage.

It is all too easy to forget the underlying mechanics of price movement. Price chops around in a small range (remember when it did that) when very few buyers/sellers (PEOPLE) have any real conviction (FEELING) or need (MOTIVATED = feeling) to buy or sell.

On the other hand, price moves directionally when many buyers or sellers (PEOPLE AGAIN) have a strong belief (FEELING) or desire (FEELING) or need (MOTIVATED? = feeling) that the price will keep going and either

1. they are afraid (feeling) they will miss out

2. they are afraid (feeling) they will lose money.

Another reason that prices move directionally (and fast) is that the majority of people either are or want to be (out of desire or need) to be on the same side of the trade. By definition, this leaves few people to be on the other side and a relative lack of liquidity.

This may all seem elementary but it is very germane to what we have been seeing lately – from either the global macro credit crisis viewpoint or the 1 minute average true range viewpoint. How can that be you say?

Well for starters, one of the pillars of the story of where we are in the big picture is the lack of liquidity in the complex structured debt contracts dreamdt up by trading desks around the world. Once Bear Stearns admitted to trouble in those privately traded contracts, all the other players went “no bid” and the cards started tumbling – because there was no one else to take the other side of the trade. This link speaks tangentially to the resolution of this problem – i.e. hedge funds declining to trade these “OTC” (read potentially very illiquid) contracts.

The other side of the trade

On the other side of the spectrum, the ranges we are seeing both intra-day and even in very short time-frames are the result of more market-players (people) wanting or needing (which makes them want) to be on the same side of the trade.

The point of all of this? Traders make money when they correctly ascertain where other players in their time-frame are and where they are likely to WANT to be in the near future (again according to their time-frame).

In other words, it isn’t just lines or bars or even a back-tested set of probabilities. It is the probability of what other people (even if they use computers to execute) are going to want or need to do in your time-frame.

Is it possible to think of the markets this way? It is a good idea?

Markets are nothing more than the reflection of human beliefs and feelings. It doesn’t matter how anyone decides upon a price at which they might buy or sell, once they “are in” it is a belief about the future (10 seconds or 10 years) that is at least the underlying REASON (ironic) they have a position.

Most of us think about the markets as an abstract series of numbers when really those numbers are just like avatars for the people behind them. Let’s suppose you trade using a complex mathematical algorithm which arbitrages gold and silver futures. It sounds as if you are trading off of the probabilities inherent in your analysis doesn’t it?

Well in reality you are trading off of your BELIEF (which you feel as the feeling of confidence – more or less so) that the model will accurately predict the movements of price in the future…. and that is always the way it is – global macro fundamentals or sub-one minute high frequency… it is always about what you BELIEVE/FEEL about what some other human will pay in the future…

Understanding this leads then to the absolute prerequisite that you understand your own beliefs, feelings and biases in order to produce the maximum in excess returns your trading is intended to create.

1. Markets are human

2. Humans make decisions and take action out of emotional foundations

3. Understanding one’s own emotional foundation enables one to make the best decisions about human markets.

Does this sound nuts?

At this point, it goes without saying – the entire world is gripped in fear. .. and for good reason. Forgive me for disagreeing with FDR but it isn’t that “the only thing we have to fear is fear itself” but “the only thing we have to fear is acting on our fear AT THE WRONG TIME.” Sometimes fear makes us act in a way that protects us – like if someone is about to assault us or we see a car speeding through an intersection (well okay in NYC we say to the car – “Dare you” – but that is – well – it is New York and we are “odd”.)

The facts are that no one knows what is going to happen and that it is clear, lots of people are selling. Does that make it seem like a good time to sell? Is it usually a good idea to do what most other traders and investors are doing? … The truth? It depends on your time frame. If like me, you sold today at 3:50 and covered at 4:00 then it was good to be doing what everyone else was doing. If you did what I did earlier, then it wasn’t (in fact I had some money to make back so thank god for that last swoosh).

Two questions you should always know the answer to -

1) What is my time-frame?

2) What is really driving me?

…the answers will always lead you to a better decision!

The question I get all the time is “Okay I buy this idea that emotions infuse all decisions and that is indeed the way the brain works, but how do I handle that any differently?”

Regardless if you are building a probabilistic model to trade gold against oil or tape-reading the E-mini Sp’s on a high-frequency, sub-one-minute time frame, the key questions are

#1) Am I aware of being nervous or excited in any way?

#2) If I can sense any such feelings, ask yourself, what is really driving this feeling? Is it your investors, the head of the trading desk or your own need to trade well? Furthermore, what is the unspoken expectation? This is the key. There will be one.

#3) How true is the unspoken expectation? Also, are there alternative outcomes instead of the one you are imagining?

At this point, you will have begun to use your emotions as information and your brain will most likely be more calm. You will also have more alternatives in your head for whatever decision you are faced with.

Let me know if it works -

A professor from Northwestern, Dr. Camelia Kuhnen, who was co-author on the 2005 study showing emotion circuits firing before “deliberative choice” circuits in a simulated stock/bond investing game invited me to this annual meeting of the Society of Neuroeconomics. All of the presentations and something called “poster sessions” review the very latest brain research – stuff that hasn’t been released in journals yet. One kind of has to be into brain anatomy (which I more or less am) but there is much work being done on choice under uncertainty, choice in known vs. unknown probabilities, the role of “theory of mind” (one of the most interesting for reading markets) and how the brain handles risk …(too bad some of those guys who levered up 30/1 weren’t up-to-date on their herd instincts!)

In short, what I am hearing is more detail surrounding what we already know – the human brain DOES NOT operate like a computer wherein it calculates probabilities and optimal “expected value” and then acts. A whole lot more goes on – with heuristic short-cuts, “feelings”, influence by experts and other practical ideas for a trader making the buy or sell decision.

Everyone I have talked to does seem to agree that humans can make better decisions if they are conscious – or work to be conscious? – of all of the influences on their decisions. To that end, the phenomenon of impulsivity is still in the very early stages of being studied …

One of the questions I get from the PhD students and their professors is how could we work with a group of traders to actually study what they do in their real life … any ideas about that anyone?

The idea of human risk offers a different angle on the idea of psychological capital. It is easy to think about markets and pricing as abstract entities when in reality they are the sum total of human decisions. Hence, human decisions are at the core of all bubbles, crashes, rallies, sell-offs and market volatility – regardless of what time-frame you are looking at.

But does the world really have a good understanding of how humans react and make decisions?

Not exactly.

It gets complicated but the biggest news is that emotions are actually germane to decisions. In fact, without them, traders can neither decide nor act. Lots of scientific evidence supports that idea yet books, trading coaches, CNBC reporters and most people still talk in term of being unemotional. Not to use an over-used analogy but essentially that perspective on human risk is akin to still believing the world is flat.

Reducing human risk requires a whole new understanding and strategy for dealing with the reality of emotions and their role in decision-making. Step one is to change your opinion about emotions from one of they are a liability to one of they are both information and motivation – in that order!