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.

Tags: Markets, neuroeconomics, probabilities, risk

This entry was posted on Monday, November 24th, 2008 at 12:48 pm and is filed under Emotions & Decisions, Learning Psych Cap, Markets. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.