Yet underlying much of what I hear is still the SAME assumption – control your emotions and in turn control your thinking. But ironically NOTHING could be further from the truth. Know your emotions – yes. Control – NO. Plus, why doesn’t it occur to anyone that logically you only have to control your actions… and emotions and actions are actually two different things.

It is actually a case of “focus bias” or the tendency to confirm what you already think that even though many many scholars and practitioners are interested now in investing behavior, their discussions return right to the same underlying and outdated theories.

If you don’t have your emotional neural networks working, you can’t decide what to wear in the morning and chances are, you may not even recognize clothes as clothes! The latest research shows we need the contextual information – which we feel – for our visual cortices to work.

I am thrilled in the interest … but now let’s take it a step further and get down to business figuring out how to understand and leverage the difference between Emotional Intelligence, blink and The Black Swan!

“Assumption” you say? “It isn’t an assumption Denise! It is truth!” Oh really?

First, if it is such a natural truth – like gravity or the sun rising in the east – then why is it so unnatural to do it? Why do day-traders fail at it at an alarming rate while institutions (with their MBA’s and statisticians) also fail at it has been demonstrated through the now 1000’s of behavioral finance studies and real world examples?

Aside from that basic question is the even more important one of “how does the human brain most successfully process market data“? And luckily The Journal of Finance has finally decided to publish what in my opinion is essentially earth-shattering research by Quartz, Bossaerts and Bruguier of The California Institute of Technology. This seminal and singular piece of research sheds a whole new light on the neurological processes involved in accurately reading markets. (And to boot it in turn explains why so many traders fail and why so many institutional traders can get it wrong!)

In short, …”tests show that Theory of Mind (ToM), rather than mathematical, abilities are better predictors of success in forecasting stock markets“.

Of course this begs the question… “what does that mean”? ToM is basically the ability to read other people. It is the mental capacity where you can imagine/see/”know” what they are thinking and feeling and therefore be better predictors of their coming choices of action. (See wikipedia)

In other words, if we go back and look for example at a very public decision – that of Hank Paulson to let Lehman go bankrupt – it had everything to do with the pressure he was under over the idea of “moral hazard” and very little to do with anything else.

Now that example doesn’t help you much when the market is slow and plodding and range bound but I use it because in retrospect it helps people see how a concerted effort in the Summer of 2008 to understand the human dynamics of the decision makers scenarios would have yielded a better idea about what was likely to happen. What I mean by that is if you specifically tried to play out the possibilities post Bear Stearns and pre-Lehman…. you would have come up with “they let at least one bank fail”. Once you had that idea you could see AIG was going down too!

Conversely all the modeling and probability thinking in the world would NEVER have gotten you there!

You can read the original research yourself @ Encoding Financial Signals in the Brain … or on the Social Science Research Network. (The latter compels me to point out that Antoine (Tony), whom I have been bugging for over two years about this, is an Electrical Engineer and he was kind enough to email me this week and let me know the paper had finally been accepted!)

Now the question is how much will the behavioral finance tendencies of status-quo and confirmation bias kick in … and prevent a large majority of people who care about reading markets from really grasping how to capitalize on an assumption turned upside down?

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.

Having just received (Thanks Sandy!) my copy of NEUROECONOMICS, Decision Making and the Brain, edited by Paul Glimcher (NYU), Colin Camerer (Cal-Tech) Ernst Fehr (University of Zurich (wonder if our French PhD Chick knows him?)) and Russell Poldrack, UCLA, I personally am all giddy over the avalanche of research demonstrating what I have been karping about for years now – feelings & emotions are part and parcel of all decisions – so we might as well figure out how to use those ephemeral psychological dimensions to our advantage.

To quote (and back to the topic) “Over the first decade of its existence, neuroeconomics has engendered raucous debates…” Raucous debates – over neurons? Really? … well you see, scientific advances typically are met with great resistance. (See Structure of Scientific Revolutions by Thomas Kuhn). In my mind, it was Damasio and Descartes Error that got this field going. He is the now USC neuroscientist (Iowa before) who studies the unfortunate individuals who have had the experience of brain damage that destroys their ability to feel emotion but leaves their cognitive capacities intact.

Neuroeconomics itself however is simply the study of what brain anatomy and functions are happening while we are making decisions that involve financial or social rewards – i.e. money in the former. The idea is that no matter what else anyone wants to theorize, that in the end, seeing what the brain does and how it does it will settle once and for all how our minds really work.

For our purposes it is about how we perceive and react to “risk”. Of course the neuroeconomists (and John Keynes before them) don’t think as traders we are dealing with risk. Risk to them is precise and knowable – i.e. likelihood of drawing an ace in a four-player one deck game of blackjack. Markets however are unknown, imprecise and ambigous – always.

The whole idea of psychological capital is therefore to maximize that side of the “probability” so that the judgments we make regarding the unknown, imprecise and ambigous prices can be the best judgments.

A couple of things to keep in mind

1. The brain assumes the next trade will be the same as the last – which is why you want to press it after winners and get skiddish after losers.
2. The brain knows the difference between card games and markets – even if we try to make markets look like card games. (We are better served to remain conscious that we are trying to trick our innate brain’s ability)
3. An upcoming study will demonstrate that it is the ability to read the other – not the ability to think in probabilities that is the real skill in trading.

…. okay the text is 8.5 x 11 and 500 pages long so they have lots more to say besides that…. but all in all, you might not need to know anymore – despite my personal fascination with the subject.

Go see the video at the website of Beatrice Gelber

The brain is an amazing thing.

Happy Merry to ALL

DKS