Virtually everyone believes that the key to investing and trading success lies in a better read (and execution on) probabilities. “Expert” after expert, from retail educators like “Be_a_GR8Trdr” to financial engineering labs in Boston, rely on this assumption.

“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?

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.

Here’s an ironic twist – research shows it is easier for the human mind to comprehend and leverage probabilities and logic IF the question is posed in terms of people versus cards, numbers or objects. Yet research also shows that we continue to build arsenals of data in the form of numbers and that in fact we also feel much more comforted when we believe we understand the numerical probabilities of a future event.

Does anyone else see the irony here? The latter is called “the ambiguity aversion” and the former the Wason Selection test and it seems to me that the ultimate question of consistent trading or investing success is the ability to bridge the gap – i.e. know the numbers but know them in the right context – the context of predicting other people’s future perceptions and behavior.

Try it sometime – in a situation where you don’t know what to do or specifically in a trading/investing decision. Ask yourself – how will the others react?

Yes I know – it seems too nebulous a question. I am fairly certain however that if you can put the anxiety about not knowing who the others are or what their motivations might be into words (therefore dissipating the discomfort of “nebulous”) and then think about this question, your answer will help you be more accurate in whatever you are attempting to predict.

(Oh yeah – one more thing… if you think you are NOT attempting to predict when you are trading, think again.)

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”.

One of our ever-detailed assistants Sandy noticed yesterday that Marginal Revolution ran a piece about last week’s FT article on me and in fact included a link to the first popular article I ever wrote. I would have preferred a link to Radical Neuroeconomics on AllAboutAlpha.com but hey, live in the public eye – risk the public eye! Plus, given that article’s title, the characterization that I have an “attachment to Freud” is understandable even if not quite the whole picture.

My actual attachment is to the idea that the human unconscious plays an enormous role in all decision making and an even more specific role in risk decisions. As Freud was the first to really bring this idea to the public, I must credit him with that. There are glimmers of it in Shakespeare and earlier writings but no one before Freud is considered the father of the idea. (Additionally, I personally credit MODERN psychoanalysis and Dr. Hyman Spotnitz for my individual victory over the world of market demons but that is another story altogether.)

Today’s neuroscience of emotion, (see this post) neuroeconomics and even neuropsychoanalysis is revolutionizing our understanding of the brain literally with every passing day. While we still have a long way to go (think Christopher Columbus’ map to what would be “America”), we know orders of magnitude more than we knew a decade ago.

For example, did you know that essentially the old triune idea of the brain is out or that it appears we need functional EMOTIONAL neural networks for our visual cortex to work? Furthermore, did you know that your brain will see the market much more like a jigsaw puzzle in which 1/3 of the pieces are missing – and it will fill in the blanks through referring to context. How often does context change in a market? (I.e. what does Dow 10K mean in 2009 vs. 2008?).

I could go on – but alas won’t. I will invite anyone interested in the new psychology of risk to wander around here. Hopefully you will find a thing or two that gets you started on the path to ReThinking Thinking.

Somewhere down the road, you just might find you agree with more than you expected. Or worse, learned a thing or two about making better decisions in the face of UOUP (rhymes with soup) – uncertain outcomes uncertain probabilities.

From the latest issue of The Economist:

JUST before the hovering finger clicks the mouse to trade, there is one thing that online investors of the future might want to check: their “Rationalizer”. The device, a prototype of which was unveiled this week, is an emotion-sensing system designed to help investors keep a cool head when buying and selling. [...]

The Rationalizer, which is still under development, consists of a bracelet that measures something called a galvanic skin response. This is a change in the electrical resistance of the skin which can be caused by various stimuli, like anger or elation. It cannot determine if the emotional arousal is negative or positive, only that it is happening.

ABN’s interest reportedly stemmed from a study by Andrew Lo and Dimitri Repin, “Psychophysiology of real-Time Financial Risk Processing” (Journal of Cognitive Neuroscience, 14(3), pp, 323 – 339,  2002), showing that day-traders who exhibit more intense emotional reactions also have significantly worse trading results.

One may question the efficiency of using this new device, trading performance wise. My guess is that this kind of practice is based on a somewhat misguided view on emotions. This view emphasizes the negative effect of emotions on behavior, the idea being that emotions vitiate rational decision-making. Here “emotions” stands for “passions.” Automatic emotional responses mediated by structures such as the anterior insula or the amygdala – see Joseph LeDoux’s beautiful book “Emotion, Memory, and the Brain” (1994) for the functions of the amygdala in fear conditioning – would trump higher-level responses mediated by the prefrontal cortex. Very Platonic stance, sometimes referred to as “dual process theory.”

This is not to say that emotions never prompt us into the wrong direction, they surely do, often “short-circuiting” logical reasoning and long term planning that are essential to efficient trading (Cf Andrew Lo and collaagues, “Fear and greed in financial markets : A clinical study of day-traders” American Economic Review, 95(2), pp. 352-359, 2005). The dual process theory is thus heuristic in that it highlights such phenomenon. However, it may lead to a hyperemphasis on emotions as sources of mistakes. Such hyperemphasis is wrong-headed. Because in many domains, nonconscious emotional biases drive behavior before conscious knowledge does; without such emotional inputs, overt knowledge is in effect insufficient to ensure rational behavior.

Antoine Bechara, Antonio Damasio and colleagues highlighted this role of emotions in implementing rational decisions (”Deciding advantageously before knowing the advantageous strategy“, Science, 275, pp.293 – 1295, 1997). Further, John Allman, an eminent neurobiologist from Caltech, has been pinning down the role of the Von Economo Neurons (VENs) of the anterior cingulate cortex in providing humans with a system for quick and intuitive behavior in the face of uncertain ever-changing conditions. This work stresses that in complex situations involving fast intuitive assessments, such as day-trading, fast intuitions are melded with slower, deliberative judgments (e.g. “Intuition and autism: a possible role for Von Economo neurons“, Trends in Cognitive Sciences, Volume 9, Issue 8, pp. 367-373, 2005), whereby emotions are best viewed as informational inputs serving deliberative processes. Consistent with this view, recent studies on decision making under uncertainty has revealed the amygdala and the anterior insula to provide uncertainty signals. See, e.g., the paper by Wofram Schultz and colleagues “Explicit neural signals reflecting reward uncertainty” in Philosophical transactions of the Royal Society of London. Series B, Biological sciences, 363(1511), pp. 3801-11 (2008); or the one by Tania Singer and colleagues “A common role of insula in feelings, empathy and uncertainty” in Trends in Cognitive Neurosocience, 13: pp. 334-340 (2009). A famous paper by J Coates and J Herbert, “Endogenous steroids and financial risk taking on a London trading floor” (PNAS, 105(16) pp. 6167–6172, 2008), helps pinning down the nature of these uncertainty signals: these may be relayed to the neural structures involved in decision making through neuropharmacological signals. For instance cortisol, which has receptors in the insula and the amygdala, would signal market risk in the brain.

All this suggests that emotions are key information providers when deciding under uncertainty. They make us tuned to our environment. Actually, in some contexts of fast and intuitive decision-making in the face of unstable (high vol) conditions, one expects that the stronger the emotional uncertainty signals of the day-trader, the higher the performance. To be more specific, I would not be surprised that for a trader “in the zone” at a particular point in time, the light pattern of  “EmoBow” (the object displaying a moving light pattern to illustrate the user’s mood) reach a deep red. Shall one conclude that the trader is too aroused emotionally at that moment, and hence should take a deep breath? Or merely that he has achieved a state of focus that intense, that all the relevant stimuli in his environment are integrated as emotional inputs? In the second scenario, stopping the decision process is like stopping a high-speed driver in the middle of the race.

In 1952 Harry Markowitz effectively founded modern finance with his seminal paper “Portfolio Selection“. The famous (or infamous) CAPM and Efficient Markets Hypothesis, for all practical purposes, evolved from the Nobel winning ideas in this paper. (Note to self: resist urge to make Nobel joke). Ironically however virtually no one knows that Markowitz himself said his paper began with step 2! Step one was deciding what you believe.

We hear a lot from the well known trading coaches about conviction and it strikes me as funny because conventional risk wisdom says “don’t get married to an idea”, “let the market tell you”, “take what the market gives” and other such axioms all based on the idea of maintaining objectivity and essentially not becoming full of conviction.

Well which is it?

I mean we also hear “believe in yourself” but where do these advisories leave you when a trading idea is going wrong? How do you handle the teeter totter that holds belief and conviction on one side and price and risk management on the other? What fulcrum can you depend on?

We of course have our answer…but before we talk any more about it, we would REALLY like hear yours!

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.

Back and rested from a weekend trip to academia -

The annual Society for Neuroeconomics meeting, held in Evanston this year, reviews a cornucopia of pre-publication research papers centered on the topic of decision making under risk and ambiguity. With everything from electrodes being implanted into patients who were having brain surgery for intractable epilepsy to the actual formulas of computational neuroscience (which a hedge fund or two lists as their primary strategy) to the one-trial learning of a Monterrey Bay slug, there is an almost incomprehensible amount of information presented over the course of three days.

A couple of extrapolated highlights especially for speculators though -

#1) Inter-temporal discounting refers generally to the phenomenon of taking the money and running – i.e. “why can’t I just wait until my target“? There were numerous studies presented both in session and on poster boards… too many for this short de-brief. Stay tuned -

2) Too many choices reduces the likelihood of a choice at all.  Colin Camerer (pronounced cam-er-er) presented this last and given his stature as a game theorist and neuroeconomist… it was worth the change flight fee!  Too many things on your charts anyone?

3) Courtesy of Nichole Lighthall of USC – under stress, men will react by “more trials” (i.e. over-trading?) whereas women will react by being more careful. Sound familiar?

4) Cal-tech is again coming to aid of the Theory of Mind idea in perceiving and executing in complex games. (In other words, the Social Markets Hypothesis). This IS going to be big – and the original paper does appear on its way belated way to The Journal of Finance per Dr. Peter Bossaerts.

5) And just to make your day – The University of Iowa discussed in some detail why if you engage in “self-control” (i.e. sticking to a trading plan), it is experimentally proven that you will subsequently have less ability to engage in “self-control”. … This could be a disheartening fact for many short term discretionary or even model based traders… but look at it this way, at least it isn’t just you!

So… just a few highlights… and points to look forward to as Trader Psyches and our new parent The Re-Think Group discusses The Psychology of Risk over the next few months!

Oops – one more – our “French PhD Chick” Elise is defending her dissertation on October 9th in Switzerland. Wish her luck and we (sort of) look forward to changing her name to Dr. Payzan Le Nestour. We also hope to bring her to the US as an advisory researcher!

A year ago tonight I was merrily watching my Cleveland Browns actually win while on a Jet Blue flight to the CME’s Inaugural Global Financial Leadership conference when my first cell beep on landing was Bill Long calling to say LEH was BK and ML was BAC. 365 days after that watershed event we have endured the panic of complete financial destruction, more than adequately blamed Wall street, inadequately blamed (imo) borrowers, the rating agencies and mortgage brokers but most of all, inadequately attempted to understand the human decision processes behind these events.

Rarely does anyone stop to think about “how do we think” – “what goes into the process”? For one, we think we know. For two, and probably more importantly, BLAME is easier and actually much more fun.

Well to that I say 1) We barely know and are just now, through neuroeconomics, beginning to put the jigsaw puzzle together and 2) blame, vitriol and the almost certain associated regulation isn’t going to stop the next “Black swan” as long as the underlying causation isn’t fully understood – which is exactly where we are.

It is far too easy to assign responsibility to “animal spirits” and “greed” …. but it is not clear at all that neuroscience would support those two well-accepted demons. For one, animal spirits generally can be taken to mean emotion and unbeknowst to those who care about markets – whether on Main or Wall – is the fact that without emotion, nary a single decision can be made. In fact, the latest news is that without emotion our ability to see and identify objects might not even work. Think about that – without emotion you might not even know if you were making or losing money!

Furthermore, to the topic of greed specifically – a number of experiments show that it isn’t about making more money – it is about the fear of regret over not making money that you could have made. THAT is a whole different ballgame. It means for example that Morgan Stanley or Citigroup, while they may have recognized the ensuing wobbliness of MBS’, it was hard to stop… or as Chuck Prince, then CEO of C infamously said, (roughly) – if the music is playing, we have to keep dancing.

In order to have even a remote chance of averting the next killer black swan, we simply have to come to understand the true role – both good and potentially bad – of feelings/emotions in perception, judgment, decisions and actions. Right now we are still on the complete wrong track thinking that regulation, pay-cuts and better models will solve the problem.

Markets are a game of predicting of other human behavior in the midst of changing circumstances- social markets vs. efficient markets. Our brains understand them as such and use context to interpret the data. In the use of context, we rely on implicit learning to which we may or may not have conscious access. The trick is to start getting conscious access – that is the ONLY path to fully objective decisions. And actually it is the only path around fudge factors and confirmation biases in model building too.

In other words, deliberate understand and conscious access to how our brains understand risk – the psychology of risk – is the true uber-risk management tool. Conscious access, by definition,  means internal and external emotion analytics.

In short, it is time to Re-Think Thinking.

More to come….