There must be 10,000 lists like this… let me add mine – hopefully with many useful twists.

1. You need to know what you are looking for – both to enter the market and to exit.

2. You need to know what the variations on #1 are – and what they are not!

3. You need to know what is imprecise about what you are looking for – it is more than you think.

4. You need to have thought about the imprecision long before you sit in front of the screen and certainly not just as you push the button.

5. You need to know what it will feel like if you turn out to be wrong.

6. You need to know how you will handle, manage, learn from and deal with that feeling.

7. You need to know what it will feel like if you are right – and again, how you will handle, manage, learn from and deal with it.

8. You need to know how to operate on the premise that “perfect is the enemy of the good”.

60 seconds in and Ohio State is plowing down the field. As I write this sentence, they dropped the ball in the end zone. … Try it again – 3 and 10 and in!! Now the question relevant to trading and risk psychology is … 15 minutes ago did they KNOW that was how it was going to go? Did they know exactly what the Oregon Ducks were going to do? Well of course not you say….

Okay then… can someone explain to me how the game, and particularly the QB’s job, is any different than being a trader or a portfolio manager? I mean sure they have a plan and they have studiously developed and trained-for expectations but don’t they still have to think “on their feet”? Don’t they have to assess the situation and make nanosecond judgments?

Why does everyone buy the widespread idea that traders have to come up with “plays” and then in turn execute them in a robotic fashion in the game of the markets? What happens to the need for judgment when faced with changing volatility? What happens to the need to use your brain in the toughest game on the planet?

Yep it is easier to NOT to have to use judgment… but is it realistic? I mean should stops and targets always be the same? Does that idea make ANY logical sense in as fluid environment as the markets present?

And in fact – worse, what is the downside to believing in the myth of the robot following the plan? There is one you know… and I submit to you that it accounts for some large % of the fact the vast majority of traders can’t consistently and reliably take money out of the markets.

And if it isn’t quite a robot – the isn’t it judgment? And if you have to use judgment at all … then what do you have to do to improve it? What do you have to do to capitalize on the fact that it is an asset?

This is a thought experiment… it is meant to help those who try it learn something… or at least stretch our minds to the point that we see the situation more as it really is.

A few weeks ago I trekked to Cambridge for Harvard’s annual Investment Decisions and Behavioral Finance conference. Excited to hear a speaker list that included renowned economist Richard Zeckhauser, MIT’s Andrew Lo and Michael Mauboussin who recently authored THINK TWICE, The Power of Counter-Intuition, I admittedly however didn’t know quite what to expect.

Reflecting now – two plus weeks post – I realize I haven’t drastically changed my long-standing opinion regarding the difference in content and value between the field of behavioral finance and neuroeconomics. BF (for short) describes and documents the inordinately probable likelihood of not seeing all the data, of seeing only yesterday’s data and of making so called “irrational decisions”. In fact, at Harvard in November, BF even demonstrates that a room full of 75 portfolio managers fall prey to the exact same perceptional “deficits” as the general population. Neuroeconomics on the other hand is attempting to reveal exactly what is happening in our brain (or at least where it is happening) as we make these well-known errors in judgment.

Anyone who has followed our thinking for any period of time knows that we explain these behavioral tendencies under the general rubric of acting out unconscious emotions and I didn’t hear a single word that dissuaded me from that position. What I did however hear and realize is  that BF as a body of work gives us a list of cognitive/intellectual strategies we all can use simultaneously alongside the pursuit of greater emotional awareness and skill to help us make better decisions.

I think however the problem is in categorizing the list of so called “biases”. To BF’s way of thinking, our sometimes funny, sometimes sad tendencies to not see information that is either right in front of us or glaringly obviously missing (and we should therefore realize we have to look for it) are called biases. For example, we have a confirmation bias – the tendency to see all data in a way to proves what we already belief. (If you can think political leanings here.)  We also have a tendency to research a problem in terms of data we already have and fail to look for data we don’t. Generally, this is considered the availability bias.

As the weeks go on, this blog (and our upcoming December online workshop) will outline the biases and how to work with them from an intellectual point of view.

Before we get started on that however I submit for your consideration the research that shows we update our beliefs, preferences and decisions in ways that keep us feeling good (Kuhnen and Knutson, 2008) and suggest that the real underlying cause, regardless of where it happens in the brain, is the emotional impact of finding, seeing, using new and possibly contradictory data.

One more thing for today – speaking of “where” in the brain … many a respected academic still talk about the triune model of the brain proposed by Maclean in 1990. Theoretically, we have a higher reasoning brain, a mid emotional brain and a lower “keep the heart” beating brain.

With NO disrespect meant, this idea is outdated. Beginning in the late 1990’s we started getting pictures of real live healthy brains and it is clear now that emotional neural networks infuse, integrate and work reciprocally with those ostensibly higher brain centers. In essence they are higher yes  – but only because they are at the top! The most recent research however shows they are non-functional without infiltrations from the emotional networks (Damaraju et. al., 2008) so I again submit the idea that understanding the reciprocity and sequencing between brain centers offers us our best possibility of defeating our otherwise seemingly entrenched “biases”.

Evidently I just can’t get enough of what the Ivory Towerites have to say about the “brain on risk“. This weekend, despite Open House New York and two of the three living creatures I must tend to out of town, I found myself listening to Joseph LeDoux of NYU, David Brooks of the NY Times and  5th year post-docs from as far away as Peking talk about their latest findings (or thoughts in the case of Brooks) regarding how our brains use, perceive, process and react to emotional data ... and I LOVED it!

See the real reason Trader Psyches exists (full disclosure here) is of course, like every student of any form of psychology or psychiatry, I wanted to understand my own thinking, decisions and actions – particularly in relationship to my ability to easily take gobs of money out of the market but almost just as easily – okay even more easily – give it back. (I have cured the second btw – and yes with my own methods).

Believe it or not, social and emotional (affective) neuroscience holds the key. Questions like how does the brain interpret symbols that represent other people’s intentions versus how does the brain interpret direct physical evidence of other people’s intentions (a raised fist or pointed gun for example), go directly to the heart of the matter of trading in a pit versus trading on a screen as well as in the case of the aforementioned, directly to chart reading.

Evidence is mounting that despite the widespread belief that markets are about numbers and probabilities in fact our brains are not fooled and know they are about predicting other traders and investors intentions and future motivations. In other words, maybe the reason so many people have such a hard time consistently thinking in terms of probability is that the brain knows that just because you have a hammer, a hammer isn’t necessarily the right tool for the job!

A couple of specific points – and names of researchers to ponder – (in many cases this data comes from what are called poster sessions where doctoral and post-doc explain their latest research so it isn’t published yet.)

1. Pranjal Mehta, Columbia University  “Neural Mechanisms of the testosterone-aggression relationship: the Role of the OrbitoFrontal Cortex” A couple of the salient points for trading here 1) any effects of testosterone were relevant within gender norms or in other words, women with relatively high testosterone compared to other women showed the same effects as men with relatively high testosterone. Take home for female traders – you know that news item a few years ago about traders in Europe and testosterone and lengths of fingers… don’t worry about it!

Ancillary points include the location of the actions (frontal cortex) and the complex interaction of testosterone and cortisol. Why do they matter? – more evidence that our higher brains aren’t just extraordinary computers and maybe the whole widely held assumption that our brains CAN work like ultimate computers needs revised!

2) Kateri McRae, Stanford, “Bottom-up vs. Top-down emotion generation: Implications for emotion regulation”. (Now as any regular follower of ours knows I think the whole emphasis on regulating emotions is mis-placed because the FACT OF THE MATTER IS, you only have to regulate actions! Nevertheless, the concept of modulating one’s own emotions still permeates lots of the science so my other attitude is let’s see what we can learn.)

The most salient point here – and I quote  – “Reappraisal paradoxically INCREASED amygdala activity during bottom-up generated emotion“. Okay I know that the meaning of that isn’t intuitively obvious to a trader (otherwise why would you even be reading this?) so let me explain. I think it is safe to say that the most widely held BELIEF regarding changing negative emotions centers around the ideas of re-framing or in layman’s terms, changing your perception about the meaning of something. All kinds of official and pop psychology strategies including NLP or “neuro-linguistic programming” rely on the idea that if you change how you think, it will change how you feel.

What this study is saying is that process worked for certain processes like interpreting “words, statements or autobiographical memories” but it not only did not work for more basic interpretations like “phobic objects” (red on your P&L) but in fact, when tried with more survival (my word) type emotional reactions, it actually made it worse.

All I can say is Hallelujah! If I have answered a question about NLP or re-framing in a trading psych webinar once, I have answered it 1000 times. “Do you use, believe, recommend etc. NLP?” I am always adamant, militant and maybe even rude because I am so sure it doesn’t work when it comes to losing money (based on talking to 1000’s of traders and the a priori knowledge of the centrality of emotion to perception) and I know it tends to make it worse because when tried you have not only a negative trade but an additional experience of failure to deal with!

So… how to apply? If you have tried reappraisal or what most call reframing or even reprogramming and it didn’t work for  you, don’t waste one second wondering or worrying about why. The Darwinian nature of trading and the conscious and unconscious meaning of a red P&L is almost certainly a “bottom-up” emotion and behavioral & brain picture evidence says that strategy worsens the situation.  (As an aside – you’ll find more around the blog but in short try words instead – put the feelings into words. Write it out or talk it out – without judgment. No one at the conference will verify this technique but give it a try – and let me know.)

… I skipped the end of the meeting today (just to write this post but yesterday ended with David Brooks calling for  those who will create a revolution by bridging what science knows about how we think and the long held misunderstanding that we are single, isolated beings rationally maximizing our utility. I can only hope that Mr. Brooks will consider Trader Psyches and our new parent The ReThink Group an element of that revolution.

In order to really understand either what went wrong in the credit housing bubble or to improve institutional or individual risk management processes, one really needs to take a step back and rethink their thinking. We tend to believe that we know how we think or even worse, that we know the best way to think (after all didn’t we go to college to learn to think?) but given the advances in brain science in the past decade it is clear that we really don’t know how it is we think.

Thinking is germane to analysis and decisions and in turn confidence and beliefs are germane to implementing a decision. I still can think of no better way to say it than Colin Camerer of Cal-Tech and his co-authors Lowenstein and Prelec when they said “It is NOT ENOUGH (emphasis mine) to know what SHOULD be done, one must also FEEL it.” Well invert that and you get that all doing has a feeling associated with it.

Now Damasio and Bechara showed us this from The University of Iowa and USC starting in the early 1990’s but word really hasn’t hit Wall Street (or Washington either btw). Behavioral finance observations confirm that we indeed feel better when we rely purely on mathematical formulas but the real world doesn’t always fit into an equation.

And guess what – our brains (particularly on risk) know it! On the majority of days, it works fine to do it the old way. But doing well in the middle isn’t what makes you the real money or saves you from the black swans – that requires knowing what to do when things DO NOT go according to plan.

The solution lies in using our “maths” within the context of consciousness about the foundational and relevant qualitative data. Our brains are good at pattern recognition – call it implicit learning or intuition – it is the same. The problem is we don’t value that data – partially because we don’ t know how. In fact not all that long ao it wasn’t blink and Malcolm Gladwell getting $100K to talk about it, it was  only “feminine intuition.”

The key tenets to build an integrated decision making system for risk and the markets?

1. Never forget that you are betting on what other people will perceive about the same bet in the future

2. Know that they think a whole lot like you (whatever level you are at).

3. Ask yourself how your tools and formulas help you better understand their future perceptions. (Btw that is called Theory of Mind or Mentalizing in the scientific world).

4. Ask what can you do to improve your models and algorithms to better reflect the likely decisions of the competition. An example in the trading world is learning to use, read and interpret volume – particularly volume at price.

5. Next look inside – ask yourself what beliefs you bring to your risk decision. Get them out in the open because they have the amazing ability to create unrecognized biases.

6. Ask that question about your beliefs and the market and about your beliefs about your role right now in decision making. The latter will lead you to your own self-perception and its possible coloration by past experiences having nothing to do with trading or risk decisions. The latter is personality and life based.

Yeah you could call this the touchy-feeling approach to risk management (I suppose) but see the thing is, your brain is using context, pattern matching, probability judgments about the unknowable – and therefore so should you! Work with it – not against it.

1.    Realize that numbers reveal only ¾ of the picture.
2.    To see 99%, wrap all numbers in a cocoon of qualitative data.
3.    Elevate qualitative analyses to the level of quantitative analyses.
4.    Leverage how all human brains interpret uncertainty.
5.    Differentiate implicit learning from impulse.
5.    Never forget which game you are playing – poker or rugby.

When we first learn anything, we need to do it consciously, deliberately and intentionally. Think back to learning to write in cursive in 2nd grade – each letter was formed with much focus right? (Did you know they are leaving that OUT of grade school curriculums these days?). Then by the time we got to high school, we didn’t give a squiggly A or Z a thought but they started teaching us to think – to justify and create in classes like English and Sociology. College extends the process of teaching us to think and grad school – at least outside of the professions – is all about original analysis and thought.

At each step of the way, the information we learned earlier goes underground. Again, we don’t consciously, deliberately or intentionally THINK about each item of information that five years earlier we did not know.

Now tell me, if succeeding at trading is one of the most difficult endeavors on the planet, why would the process of becoming more learned and sophisticated be any different? More importantly, why should it?

Trading education, especially outside the “prop” world (OPM or other people’s money) is not like progressing through levels of formal education. There is no standard curriculum, if you switch from one school to another you might not even recognize the lingo and even in OPM situations much of what the junior traders are asked to do is sit at the screen and lose money.

What are they doing – what is that form of learning called? Experience right? And why is experience important? As dictionary.com defines it “the ability to judge, make a decision, or form an opinion objectively, authoritatively, and wisely, esp. in matters affecting action; good sense; discretion”.

But ironically most trading education tells you NOT to use judgment. “Trade what you see, not what you think” for example – well now tell me, how on earth are you really supposed to do that?

There is this bizarre overlooked contradiction in much of what passes for trading wisdom – or at least smart trading psychology. On one hand, developing a trading strategy/tactics and a plan are OF COURSE the foundation to work on but on the other, the most successful firms ask their traders to spend years learning judgment while the independent/retail world is taught not to think!

The answer to this lies in re-thinking thinking altogether. How do I look at the markets? What do I believe about how they work (on my timeframe), what style of trading suits me? And then once those questions are answered, how do I put together a strategy, tactics that embody that strategy and systematically inject my judgment – or my brain’s extraordinary ability to recognize patterns – into play in order to take money out of the market (or really from other people who are trying to do the exact same thing)?

In short, without an exceptional money-making mentor (and they are very hard to come by), traders have to create the learning progression of high school, college and grad school themselves. I submit that if they look at the thinking/judgment process and institute a program for themselves that they will do much much better than if they just try to rote follow what some other “trader” teaches them.

Is it work? Yep? Is it a LOT of work? Yep. But c’mon does it hold water at all to think that competing with other motivated traders across the planet, some who will do ANYTHING to succeed, is (or was) going to be easy?

…and one more thing, this is also the process of belief and confidence building – which is exactly what you need when things go wrong – which in the markets is a whole bunch of the time! In other words, most will tell you to go back to your plan. I will tell you to go back to your judgment – judgment you have honed through a systematic process.

What is this blog about anyway?

In short, it is supposed to be immersion in thinking about trading and behavior from a totally radical perspective – one where your emotions and feelings matter more than anything else. They will influence your perception of risk and in turn influence your decision making and the trades you take.

We get a little zealous about it because we see how powerful this realization is to so many traders. It also applies to all traders – from the newbie to the quant in Greenwich. How can that be? Well the underlying idea of you can’t make any decision without emotion is a human reality. The idea that we like to rely on numbers and probabilities MORE than we like to rely on squishy mushy feelings is well proven.

Why? Well for one – and it is a big one – it is easier. We know what to do with numbers while the qualitative aspects of feelings are something we have assiduously and theoretically wisely avoided for as long as we can remember.

That fact doesn’t change the real fact that without those feelings you can’t decide what to wear. It doesn’t change the fact that there is emotional motivation in every trade. It doesn’t change the fact that there is impulsive emotional energy in every deviation from the plan.

What it does do is mean that if you really want to make it in this business – regardless if you recently started or if you were laid off from JPM or even if you are at one of my friendly funds in NYC, the key to more effectively assessing risk is to get in line with your psychological capital. Or better put, get your psychological capital in line – front and center – and always the thing to be managed alongside of the probabilistic or mathematical risk.

ALWAYS.

It is all too easy to forget that trading (not to mention life) is a physical experience. (See Descartes’ Error “I feel, therefore I Am” by Damasio) The path of least resistance is believing that risk decisions are mainly, if not exclusively, cognitive (thinking) events.

My just-ended golf weekend in Amelia Island reminded me how true this is. On certain chip shots I thought about things like ball placement and whether I wanted a full-swing or not. On others I “thought about” what felt right. I looked at the distance to the hole and just focused on the physical experience. Ditto for putting. Which do you suppose led to better shots?

If you said “thinking shots”, you are wrong with one exception.

I tried a whole new way to hit a sand shot and it required that I consciously execute each step. I couldn’t do it by feel because I had none. And true to the intent of this letter, the response of the much better golfers I was playing with was “great, now you have the FEEL of it.”

Trading is like this. At first you have to intellectualize a risk situation. But the best results come when you arrive at the place where on top of that cognitive activity you can effectively layer an awareness and integration of the physical experience – the data that exists in your body not your head.

This is what is meant by the term “art and science”. Trading by definition cannot be a science as it is only the sum total of all human risk decisions but its numerical nature allows it to pass as a reasonable facsimile. The idea of financial engineering btw is kind of an over-statement. There is no engineering of markets. Anyway, as for the art part, the thing that is missing from almost all trading advice is how to research and interpret data that isn’t presented in statistical form. Or put another way, how to leverage the qualitative along with the quantitative.

The vast majority of experts will still tell you not to try.

The irony of that is your brain is going to interpret market data via pattern matching regardless if you want to use that input or not. Most importantly, the holistic system communicates the result of the pattern match through the physical feeling-sensory-dimension of our existence. The reason the conventional wisdom is so wrong is that it never learned to distinguish between the feeling of an impulse and the feeling of an intuition or what comes to feel like instinct. That however isn’t a good enough reason to stick with the old earth is flat/intellect is all approach.

The way we see it, the brain will always win in the end so why not get started as soon as possible on working in concert with a brain and a body that work together to assess and address uncertain situations – price movement or sand traps. The job might be as hard as learning to shoot a 90 but did you really think other traders or money managers were going to let you take their money without a fight?

Bring all your faculties to the game!

Everyone thinks the market is a game of numbers. We use complex models, umpteen oscillators or retracement calculations and even a fundamental analysis of supply and demand – all based in numbers and about numbers.

But in reality, the numbers of the market are but an illusion.

Markets are only the vacillating prices that other human beings, using the same mathematically based tools, are willing to pay. For example, what can be expensive one day can be very cheap the next if a trend has ensued.

It is only a matter of perspective. And perspective is a matter of the judgments you make.

Judgments on the other hand will be influenced by both impulsive feelings and by intuitive feelings – or pattern recognition. The trick is to have all the data on the table so you can tell the difference.

In order to do this, us market participants need to do a couple of things – give up the notion of a iron-clad trading plan based purely on historical probabilities and replace it with a trading plan based on historical probabilities (yes you read that right) AND a systematic way to leverage your judgment under uncertainty. This way you can make a decision about factors that may now be in play for the future probabilities. I mean who thought the VIX could stay over 30 for 6 months? … I am just askin.

Now in order to do this successfully, you have got to learn to optimize your judgments – which means spending more time focused on deciphering and understanding them than you spend on deciphering and understanding the charts.

This is revolutionary trading psychology – and it works.