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….

Per the Washington Post “But in each instance, inexperienced officials, at times ignorant of other agency probes into Madoff, took his explanations at face value and did little to verify them.“

Why would anyone – no matter how inexperienced – take a potential criminal at face value? I mean no one intentionally tries to fail at their job do they? Is there any upside to that?

The answer goes back to Re-Thinking Thinking – or understanding how we ACTUALLY perceive and judge because it isn’t how we think – or have been taught – that we do. We believe that as children we rely too much on our emotions and as we mature, we become more rational and more objective. Well that may be true on the surface – but essentially only on the surface.

Most of our analysis is done below the surface of our consciousness – and most of it has to do with how we are feeling (or being made to feel) and we don’t even know it. In the SEC’s case, they were victimized by Madoff’s charms in the same way everyone else was. His extraordinary ability to make people feel good – to trust him – worked its magic on the young, inexperienced (maybe intimidated) investigators the same way it worked on his friends at The Palm Beach Country club and his feeder funds and his charities and his…

See the whole sordid affair is a spectacular object lesson in the reality of how we actually make decisions.

It isn’t time to just be out-raged at the SEC (although that is fair). It is time to use that out-rage to actually learn that the real job in risk psychology is to stop fooling ourselves and start being realistic about how we really think – and to Re-Think Thinking.

1.    Realize that numbers reveal only ¾ of the picture.
2.    To see 99%, wrap all numbers in a cocoon of qualitative data.
3.    Elevate qualitative analyses to the level of quantitative analyses.
4.    Leverage how all human brains interpret uncertainty.
5.    Differentiate implicit learning from impulse.
5.    Never forget which game you are playing – poker or rugby.

Being interviewed on CNBC & “ABC World News Tonight” on the same day makes it so clear to me how differently the market is viewed depending on what kind of desk you sit behind. I had no sooner walked out of the NYSE when an ABC producer rang (thanks btw to whomever changed the rules so that you can keep the same cell phone number even if you switch carriers – which come to think of it, is a factor in the economy recovery… hmm… a post for Greenfaucet –  but I digress.)

Given that I was actually in the Wall Street subway station and could barely hear, I said “Sure I can stop by after my lunch appointment with the Director of Research @  fund of funds X (hec just because I also share an apartment and two dogs with the man I was meeting didn’t seem THAT relevant)  I figured (assumed) they must want me to talk about the same thing I just got done talking about – how key levels play themselves out in market reversals.

Guess again – and note to self NEVER EVER – even if it is Charlie Gibson (or his proxy) calling skip the pre-interview! The point of the segment was to say that Friday morning’s drop in consumer confidence caused the Monday morning market swoon. But hec, to me, the discretionary high-frequency trader, Friday morning could have been 2001 by Monday afternoon.

But of course, I am the odd man out here – and not viewing the markets the way the “average investor” does. It also brings up some thoughts about the markets really do work – or the infinite loop between fundamentals, facts and fear.

Many traders and investors work off “fundamentals” – i.e. company prospects or economic data. Many traders work off “facts” i.e. the actual price something is trading at and the relationship of that price to prices gone before (some may not think these are enough but they are indeed facts – the S&P is trading right this moment at 984.50 and that IS a fact) and we all can get caught up in the two kinds of fear that drive the market – fear of losing and fear of missing out.

An uncanny phenomenon however is how the facts and the fundamentals converge. Last Friday we had been trading for 8 days at the November highs in the ES S&P mini futures contract when a worse than expected US Consumer confidence number was released – causing the market to take an intraday swoon. Now that swoon was in the making regardless in that we had failed to close above the key swing high for days and days.

So I simply saw it as a failure of a key level – but David Muir saw it as a disappointing confidence reading. Was one of us more right than the other? (Okay I am biased but)… In reality, NO. The two are different lenses used for different types of “photographs” but both explain the subsequent price action.

Fear may be the trump card – if we are rallying hard off of a low – like one made in March – there is a rush to get in and not miss out. If we are falling hard, like we did last Fall, there is a similar albeit more violent rush to get out. And here we are right back in the loop as those rushes change the facts (price) and price influences the fundamentals – at least consumer confidence and a whole slew of other economic or company earnings data.

The lesson here – enter this infinite loop through any door – fear, facts or fundamentals. Just know which one it is so you have the breadcrumb path to get back out!

When we first learn anything, we need to do it consciously, deliberately and intentionally. Think back to learning to write in cursive in 2nd grade – each letter was formed with much focus right? (Did you know they are leaving that OUT of grade school curriculums these days?). Then by the time we got to high school, we didn’t give a squiggly A or Z a thought but they started teaching us to think – to justify and create in classes like English and Sociology. College extends the process of teaching us to think and grad school – at least outside of the professions – is all about original analysis and thought.

At each step of the way, the information we learned earlier goes underground. Again, we don’t consciously, deliberately or intentionally THINK about each item of information that five years earlier we did not know.

Now tell me, if succeeding at trading is one of the most difficult endeavors on the planet, why would the process of becoming more learned and sophisticated be any different? More importantly, why should it?

Trading education, especially outside the “prop” world (OPM or other people’s money) is not like progressing through levels of formal education. There is no standard curriculum, if you switch from one school to another you might not even recognize the lingo and even in OPM situations much of what the junior traders are asked to do is sit at the screen and lose money.

What are they doing – what is that form of learning called? Experience right? And why is experience important? As dictionary.com defines it “the ability to judge, make a decision, or form an opinion objectively, authoritatively, and wisely, esp. in matters affecting action; good sense; discretion”.

But ironically most trading education tells you NOT to use judgment. “Trade what you see, not what you think” for example – well now tell me, how on earth are you really supposed to do that?

There is this bizarre overlooked contradiction in much of what passes for trading wisdom – or at least smart trading psychology. On one hand, developing a trading strategy/tactics and a plan are OF COURSE the foundation to work on but on the other, the most successful firms ask their traders to spend years learning judgment while the independent/retail world is taught not to think!

The answer to this lies in re-thinking thinking altogether. How do I look at the markets? What do I believe about how they work (on my timeframe), what style of trading suits me? And then once those questions are answered, how do I put together a strategy, tactics that embody that strategy and systematically inject my judgment – or my brain’s extraordinary ability to recognize patterns – into play in order to take money out of the market (or really from other people who are trying to do the exact same thing)?

In short, without an exceptional money-making mentor (and they are very hard to come by), traders have to create the learning progression of high school, college and grad school themselves. I submit that if they look at the thinking/judgment process and institute a program for themselves that they will do much much better than if they just try to rote follow what some other “trader” teaches them.

Is it work? Yep? Is it a LOT of work? Yep. But c’mon does it hold water at all to think that competing with other motivated traders across the planet, some who will do ANYTHING to succeed, is (or was) going to be easy?

…and one more thing, this is also the process of belief and confidence building – which is exactly what you need when things go wrong – which in the markets is a whole bunch of the time! In other words, most will tell you to go back to your plan. I will tell you to go back to your judgment – judgment you have honed through a systematic process.

Today’s WSJ reviews Morgan Stanley’s 2nd quarter on page C1 and on D8 prints what they might not have realized should have been a companion article. It pictures tennis’ Andy Roddick and golf’s Tom Watson in “After an Epic Loss, Then What?” which discusses “soul-crushing defeats“.

Now we take for granted that losing the title at Wimbledon after the longest 5th set played requires some down time to get one’s head “back together”. What on the other hand we don’t take for granted is that trading losses – or the near death experience of your whole trading desk as in the case at MS – requires the same sort of psychological process. A sports psychologist is quoted as “take a day” but the truth is managing your psychological capital takes as long as it takes – and is the single most important task any athlete, trader or even CEO like John Mack has on their plate.

Today’s neuroscience proves that the residual feelings resulting form one event can completely color your beliefs about the next event. It also proves you can’t act – or even make a decision – without emotional inputs. Therefore, managing those inputs – in the way that works – is a singularly profitable (and winning) endeavor.

Step One - Accept and embrace everything you feel about a trade that didn’t work.

Step Two – Put all of those feelings into words – writing, typing, talking, yelling… I don’t care. The key as the brilliant psychoanalyst Hyman Spotnitz said is to “Say everything.” (Note words are JUST words and feelings are JUST feelings and neither one makes your future reality in and of themselves).

Now this sounds easy enough – but in reality it isn’t. The dominance of pop-culture thinking like “The Secret” and Tony Robbins’ NLP make this embrace of ostensibly negative feelings a bit like being accused of spreading H1N1 flu. Like the sports psych said (in so many words) – get over it. Well forgive me but does that work with swine flu? Of course not, you take the drugs, you sleep – you manage your body so that it does indeed get over it – in its own time.

This is the exact same process traders – floor, MS or independents – need to go through to recover from losses. If they do, they will truly, thoroughly and completely get over it and in doing so, see the markets in a clear way – the surest way to judge the optimal amount of risk to take.

P.S. Call us Mack if you want help. I mean after all, why should our neurons recover any faster than our bodies?