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!

Today I am being interviewed in conjunction with a project @ Columbia’s Graduate School of Business and a journalism fellowship project. Nouriel Roubini and Emmanuel Derman have been/are also on the docket for the subject of “What Went Wrong & What Can Be Done.”

The major points I want to make – and they apply to all traders – are

#1) Start with the core question – the Social Markets Hypothesis question of “what will the other guy do?” – in the timeframe you care about.

#2) Realize that numbers of any sort are just a tool to help in understanding the answer to question 1. No algorithm or program anywhere can account for the vicisstudes of human behavior and in order to most effectively deploy the algorithm/system, one needs to know its limititations. Without acknowledging its limitations, you have no resources when the tool is inadequate.

#3) Learn to research and evaluate internal feeling based data. Both value it and beware of the risks it brings – a double edge sword. Instinct delivered through the conduit of feelings can tell you things your deliberate analysis cannot (due to human brain’s ability to recognize a cat versus a dog) but unexamined feelings can lead you astray via their natural tendency to inject risk management (fear) or take the simplest route (the same thing will happen next as happened last).

Sophisticated modelers have powerful tools at their disposal but they still have to answer the same question that discretionary less capitalized market participants do. Anyone will be well served to make decisions in concert with their brain’s view on the ambigous data of human markets!

Right after “what the heck is psych cap” should come “what the hell is neuroeconomics”? Neuro on one hand and econ on the other? … Could they be more different – microscopic brain cells versus broad based financial interworkings?

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.

Someone named Robert Skidlesky wrote a book called John Maynard Keynes: 1883-1946: Economist, Philosopher, Statesman. He says that Keynes said “not all future events could be reduced to measurable risk. There was a residue of genuine uncertainty and this made disaster an ever-present possibility, not a once-in-a-lifetime ’shock’. Investment was more an act of faith than a scientific calculation of probabilities.” (The New York Times Sunday Magazine 12.14.08)

We couldn’t agree more – regardless of timeframe. And neuroeconomist research (Check out Hsu or our French PhD chick’s posts) is even providing pictures of our brains acting on this faith versus “scientific calculation of probabilities”.

Not that us traders shouldn’t attempt to create market strategies and tactics that divine the probabilities but when we do so, we will be better served to remember that in effect we are using a crude tool – no matter how precise it may appear. Any effort to predict where the market will be is indeed a prediction on the future – be it in 10 minutes or 10 years.

Furthermore, our brains seem to be wired to rely on feelings when they detect inherent uncertainty – or imprecise probabilities. So… all the more reason we need to understand that we are working with only an approximation no matter how complex our algorithm, chart or trading tactics are.

In short, anything can (and clearly does) happen at any time. We need our BRAINS – which happen to be really good at unconscious pattern recognition and dealing with imprecision to kick in – not just the sophisticated overlay we have concocted.

After all we are betting on other brains to pay more – or sell for less. It can never hurt to know what game we are really playing.

Can it?

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.

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.

Robert Shiller writes in the New York Times about the role of group-think during the upward phase of our blown-up housing bubble. He recounts the polite discounting of his warnings in Irrational Exuberance (see all of Shiller’s books) and says “speculative bubbles are caused by contagious excitement.”

He segues to the remaining gap between economics and psychology in a discussion about his experiences as a predictor of catastrophe. In doing so, he coincidentally supports the neuroeconomics research in a new paper by Drs. Camelia Kuhnen and Brian Knutson – The Influence of Affect on Beliefs, Preferences and Financial Decisions – “beliefs are updated in a way that is consistent with the self-preservation motive of maintaining positive affect and avoiding negative affect, by not fully taking into account new information that is at odds with the individuals’ prior choices.”

Translated into trader’s English their point is that we tend not to pay much attention to information that would suggest we are wrong about something. In other words, we are less than open-minded (politics anyone?) because if we find out we are wrong, we might have to feel badly about ourselves and that is simply no fun.

Shiller mentions this exact kind of thing when he says “Economists…pride themselves on being rational. … The notion that people are making huge errors in judgment is not appealing.”

To my way of thinking – “not appealing” = doesn’t feel so good = “avoiding negative affect”.

Let’s make sure we have this straight. We don’t want to feel badly about ourselves so we “overlook” data that could actually lead us to a better decision?

Feeling “bad” for a bit could prevent us from making decisions that are going to make us feel far worse somewhere down the line. Put another way, we prefer to feel better now even if we risk feeling really bad later.

Economists like to believe we are rational. Behavioral economists noticed we are not. Neuroeconomists can show us our brains firing on emotion before logic and Andrew Lo of MIT says logic and emotion are two sides of the same coin.

What this means is that we need to learn how to tolerate feeling bad – usually for just a little bit. At first you have to think of it as the tedious research phase of an important project. (It does get easier with practice.)

“Negative affect” has protective value in it. The feelings we don’t want to have are actually on our side…and learning not only to be able to feel them but to inquire about their message can’t help but produce better decisions from those flip sides of the coin.

And that skill is a significant part of what we call having PSYCHOLOGICAL CAPITAL.

Robert Shiller writes in the New York Times about the role of group-think during the upward phase of our blown-up housing bubble. He recounts the polite discounting of his warnings in Irrational Exuberance (see all of Shiller’s books) and says “speculative bubbles are caused by contagious excitement.”

He segues to the remaining gap between economics and psychology in a discussion about his experiences as a predictor of catastrophe. In doing so, he coincidentally supports the neuroeconomics research in a new paper by Drs. Camelia Kuhnen and Brian Knutson – The Influence of Affect on Beliefs, Preferences and Financial Decisions – “beliefs are updated in a way that is consistent with the self-preservation motive of maintaining positive affect and avoiding negative affect, by not fully taking into account new information that is at odds with the individuals’ prior choices.”

Translated into trader’s English their point is that we tend not to pay much attention to information that would suggest we are wrong about something. In other words, we are less than open-minded (politics anyone?) because if we find out we are wrong, we might have to feel badly about ourselves and that is simply no fun.

Shiller mentions this exact kind of thing when he says “Economists…pride themselves on being rational. … The notion that people are making huge errors in judgment is not appealing.”

To my way of thinking – “not appealing” = doesn’t feel so good = “avoiding negative affect”.

Let’s make sure we have this straight. We don’t want to feel badly about ourselves so we “overlook” data that could actually lead us to a better decision?

Feeling “bad” for a bit could prevent us from making decisions that are going to make us feel far worse somewhere down the line. Put another way, we prefer to feel better now even if we risk feeling really bad later.

Economists like to believe we are rational. Behavioral economists noticed we are not. Neuroeconomists can show us our brains firing on emotion before logic and Andrew Lo of MIT says logic and emotion are two sides of the same coin.

What this means is that we need to learn how to tolerate feeling bad – usually for just a little bit. At first you have to think of it as the tedious research phase of an important project. (It does get easier with practice.)

“Negative affect” has protective value in it. The feelings we don’t want to have are actually on our side…and learning not only to be able to feel them but to inquire about their message can’t help but produce better decisions from those flip sides of the coin.

And that skill is a significant part of what we call having PSYCHOLOGICAL CAPITAL.

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!

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?