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!

“I must say I am finding your stuff pretty revolutionary. Just a big thank you. Just a quick question if I may: what exaclty do you mean by leverage? Your psych cap/emotions? Am I correct in assuming it means when your emotions tell you to do something (by fully experiencing the emotions) that one should then trade a bigger position, size for example, in that case?” Colin asked this question in response to the post below about old brain new brain and since it is such a great question – and comments R kinda hard to click thru to, I thought it best to bring it front, center and top!

First – I use feelings and emotions as synonyms even though technically that isn’t correct (feel a headache, feel angry …) But for practical purposes, they both are information and motivation that we experience primarily in our bodies versus our brains so ‘feelings’ ususally captures both. The idea of leveraging feelings/emotions begins with recognizing them as information.

Look at your feelings/emotions as data. Research them, seek to understand them in the same way you understand a chart. Now yes, that is a big endeavor as they, like price, are ambiguous but the payoff is at least as big as learning to read charts.

Once you are working with feelings and emotions as data, you then are on the path to being able to tell the difference between unconscious pattern recognition (experiential knowledge) and impulse - which generally can be thought of as the desire to trade something because you either want something to happen or are afraid of something else happening.

In the latter category, impulse. Impulses are feelings laced with the urge to act. Where we get revolutionary is the conventional advice which is to overpower that urge with your intellect and analysis. The problem is that the urge is taller, heavier and has been to the gym for years whereas the intellect is sleek, thin, wiry and doesn’t work out. It is funny though – if you look impulse in the eye, if you allow him to threaten you by actually feeling what he is sending out, he withers like a bat in bright sunlight. (OK I am mixing up my metaphors but…) To mix some more, try thinking of it like the martial arts, in other words, with training, you can use the “opponent’s” strength to the service of your goals.

Now what happens when you do this? By definition, you will take fewer impulsive trades and implicitly this improves your bottom line. This is leveraging emotion as a RISK MANAGEMENT tool first and most definitely includes knowing when to walk away because the impulse can bench press 450 pounds.

Now onto leveraging feeling and emotions as a strategic and tactical tool… as you get used to recognizing impulse and feeling the feelings (research), you will start to be able to recognize the difference between the feeling of impulse driven by the fear that your profits will evaporate and the feeling of instinct that your trade is not going towards your target at which point your can wisely make a judgment call to exit earlier than originally planned.

Now at this moment, the revolution really kicks in. But first, if you are following standard trading psychology you have to feel guilty and like you screwed up because you deviated from your plan. This feeling is always exacerbated by the market’s universal trick for rushing to your target moments after you’ve used your judgment or conversely rushing to your stop if you managed to stick to your original plan. These two phenomena always then reinforce that you should have stuck to the plan and you screwed up. This makes it very hard to feel confidence and it exacerbates the worry and impulse. If however you plan to use your judgment and you make the best call you can make at that point, you don’t’ take the same hit to your psych cap. When you don’t take that hit, you are a much better position to read the next trade (i.e. you FEEL MORE CONFIDENT) and know the difference between your intuition and your impulse.

The more you do this, the more you will feel it when you are really in a sweet spot and the market is about to move hard in your direction – and this Colin, when you press it – or in other words, use PSYCH CAP (feelings/emotions) AS STRATEGIC & TACTICAL TOOLS.

The thing is – all of this requires both a change in perspective and more importantly, putting the same effort into understanding your internal signals as you put into the ones the market is providing! It so happens to also leverage the brain’s reading of ambiguous market data and the fact that we are really only trying to predict other market player’s behaviors NOT where the bar on the chart is going!

DKS aka TP

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(Consider this Part 1. Obviously, revolutionary advanced trading psychology is a complex topic that can’t be covered fully in one blog post. Check out the other key words and also this page if the full course in Psych Cap is of interest)

Columnist and author Jason Zweig writes in his weekly The Intelligent Investor column that “Much like the choice of whether to invest in stocks at all, rebalancing is a bet about the future“. Forgive me but this should be self-evident – particularly to anyone who reads the WSJ on Saturdays.

The more critical point that Zweig fails to mention and most investors and traders never realize, overlook or forget is that any investment or any trade in any timeframe and based on any analytical method is a bet on ONLY ONE THING – that some other human being is going to be willing to pay a different price than you paid at some moment in the future. Markets are no more and no less.

This may seem self-evident or unimportant to some – after all, we have our fundamentals or our technical analysis and we really only need to bet on the numbers! Really? So how did betting on those things work out in the past 18 months? How did all those hedge funds do using their historical volatilities going into September 2008? Or, those day-traders with fixed stops?

See the numbers – whether from a chart or a projected cash flow – are only a reflection of or proxy for what another human will decide in a given set of circumstances. Take this example, after the run on BSC a year ago this coming week would it have been that hard to imagine that one of the other banks could go down altogether? Would it have been that hard to imagine that Paulson could buckle under the pressure and let someone who had lots of credit-default swaps go BK?

Not if someone paid to predict the markets stopped looking at the numbers, put their feet up on the desk and said … hmmm… let’s think about this purely from human behavior for a moment.

It works in much shorter time frames too – like yesterday afternoon when the ES was trying to make new lows but the speed of the downdraft had slowed and the NQ wasn’t moving down… you see that and you can be sure people are still getting short ES and there is about to be a huge short squeeze. But… if you dont’ think about the other trader’s behavior, your numbers and charts may have said shorting again was a good idea. Especially because your brain defaults into expecting the same result out of the next decision as it got out of the last – another fact that Zweig doesn’t fully articulate even if he did write Your Money & Your Brain.

With apologies for being out of touch, I would like to make a couple of notes on psych cap. First, and I have said this before in different way, it really does appear that our brains have special “curcuits” for detecting imprecision or uncertainty. In other words, that feeling that someone or something is there – even if you can’t see or hear anyone? (which would have come in handy while searching for food in the woods) most likely has its own chip.

And this chip works.

Ever wonder why you review your plan and within minutes do exactly the opposite? It is because your brain detects that the plan doesn’t perfectly fit the circumstances and it goes into “ambiguity” mode. In ambiguity mode it relies on gut-feel more than anything. …. yet who among us has really been taught to systematically use gut-feel?

In that mode most of us are lost. We can’t tell the difference between a tickle that the market is going to turn on us and residual fear left over the last time the market burned us.

Now this game ain’t easy – and to make it harder is this conflict between planning for markets in estimated probabilities while fighting our brains which are using the uncertainty circuit. There is only one solution to this – get better at differentiating amongst our feelings. Don’t blame the messenger but the data lies there.

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.