Emotional Trading Alarms

How do you know you have downshifted to your limbic brain?

Everyone knows that emotional decisions can create havoc with trading profits. We understand this when we are calm and working from our neo-cortex (our rational brain). The problem is, as the emotions increase we go to our flight/fight response, receive a cocktail of hormones (adrenal dump) and we downshift from our neo-cortex to our emotional limbic brain. Our problem is that we don’t have a way to measure this change because our neo-cortex has been hijacked by our limbic brain and we lose calibration.

Until now?

Phillips and ABN AMBRO are testing a concept device. The implications are staggering. The major political disasters have been caused by emotional reaction coupled with unbounded power. What if we couldn’t drive, vote, legislate or trade while under extreme stress?

Until this device arrives, you can still manage your own emotional state by building a new Mind Muscle™. This exercise could change your life.

By managing breathing, you can change your physiology during times of extreme stress. How you breathe paces the rest of your physiological response. Change your breathing and you change your physiological pattern. If truly mastered, you will be able to lower your blood pressure and counter most of the negative arousal effects and stress levels from the adrenal dump during a downshift to fight/flight.

Practice can be done on your own and works more effectively as it becomes automated. Ideally this exercise I call Upshift Breathing is most effective when practiced under actual stress. To begin, practice the mechanics of this breathing exercise through several cycles by yourself. Pace yourself so that each part takes the same amount of time as you slowly count to four during each part.

1. First inhale through your nose slowly to the count of four.
2. Hold your breath to the count of four.
3. Exhale through your mouth slowly to the count of four.
4. Let your lungs relax and stay empty to the count of four.

Start the cycle again.

Additionally, this visualization may help. When you inhale through your nose, do so with steady deliberation and imagine that you are drawing in the room around you. On the next inhale, take in your trading desk. On the next breath breathe in your computer screen, then the markets, then the whole economy. Hold the economy effortlessly in your lungs for the four second count. Then with a complete and relaxed exhale, experience the joy of returning the markets to their former state.

Once you have the mechanics down, take a private moment, become comfortable, and create an imaginary threatening situation. This situation can range anywhere from mildly stressful, such as an argument with a spouse, to a truly terrorizing fear you have carried for years. We recommend that you start with a visualization of an event that is mildly stressful and work your way up to your core fears.

Set an alarm for five minutes (you can adjust the time with experience) and start the fantasy. Imagine the peace you feel before you see signs of danger or stress. See, smell and hear the argument, stressful situation or danger. Visualize it in all its details with all of your senses as if it were a surround sound, 3D movie playing in your mind. Notice the effects on your body as the experience intensifies. Allow yourself to feel the full impact of the stress, anger or danger. Allow your body or voice to respond out loud.

When the five minute alarm goes off, notice what is going on in your body. Notice everything you can. Inventory your entire body: breathing rate, vision, hearing, muscle tension, stomach etc.

Now, start Upshift Breathing. Breathe slowly. Focus on your body. Notice the changes as you slow you breathing. Practice this breathing several times until you feel you have the cycle of fear and relaxation automated.

Then the next time you are staring at disbelief at your trading screen as you are stopped out of you sixth trade in a row, your boss yells at you or your spouse makes an accusation, start your Upshift Breathing cycle. Pay attention to your body at the start of the Upshift Breathing cycle. Then notice your state as you cycle through the breathing exercise. This real-time awareness is an important part of the experience. As this breathing becomes part of your life, it will happen automatically in the very real high stress trading situations where you really need it. Law enforcement officers who use this technique report that it has become automated when they feel threatened, helping them asses danger and save lives.

If you can automate this breathing response during trading, it will eliminate the majority of emotional trading mistakes. The challenge is that most of us have a resistance to deep breathing because we have contracted our bodies to protect ourselves over the course of a day, week, year and lifetime. Slow breathing not only takes you out of the fight/flight downshift to your limbic brain, but has the potential to open other life pains. So, be gentle with yourself. Notice if you intend to do this exercise but don’t. Your resistance is there to protect yourself, even if that protection is no longer necessary.

To learn more about building Mind Muscles™ and a free consultation please call.

Richard Friesen (415) 259-0652 RFriesen@MarketPsych.com

Turning Your Uniqueness into Market Edge and a Trading Strategy

We are all wired differently. We all bring different skills to trading. We all have distinct dispositions. We also have our own unique mental baggage that we deal with day in and day out.

This is good news.

Because you are unique, you can build a trading process that works for you. The ultimate goal is to accept who you are, know your skills and limitations and find a way to turn you internal trading machine into a statistical trading “edge.” Once you know your own “edge,” you can then create a trading strategy that emphasizes your edge and ameliorates your mental baggage.

Some traders need control. Others love excitement. Some traders want a clear system to execute. Others feel imprisoned by mechanical systems. We all have trading weakness that can be triggered in certain market conditions with certain positions.

A system that is built on who you are, your trading needs and ameliorates your emotional triggers can turn a volatile P&L into more consistent profits.

The first step is to determine what you really need. Not just what you say you need, but what is the underlying need. And don’t be shy here. It is ok to know that you need an adrenaline rush. There is no shame in this. It is fine to recognize a need to avoid being terrified.

Try this exercise to see if it reveals any deeper needs. Make a list of what you need out of trading. This will probably include money, but be sure to look for other needs as well…perhaps recognition, proof of your intelligence or escape.

Once you have written down all the benefits of trading, take the one that seems the most important. Then ask yourself, what you get out of this benefit. Write that down. Then ask again, what do you get out of that benefit? Write it down. Keep drilling down until there are no more underlying benefits. Then, go to the next most important trading benefit and drill down again.

For example, if you start with money as an important benefit, ask yourself, what benefit to I get out of money? The answer may be security. Then ask, what benefit do I get out of security? And keep drilling. The answers may surprise you.

You can also learn more about yourself by taking the MarketPsych Trader Personality Test gratis. It returns scoring on personality factors and biases.

The next step is to find out what your “edge” is. Edge is anything that gives you a statistical advantage for a trade. It might be pattern recognition, fearlessness in the face of market panic, discipline to follow a system, or an algorithm. What is your edge? How does it work? Why does the market not discount this edge? Why is the market going to give you profits? Make sure this edge is in sync with your skills, temperament and emotional baggage.

Once you have defined your “edge,” you can then create a system. The more clearly defined it is, the more it can be followed, tested and improved.

Understand who you are, use the best of yourself to create a statistical edge and build a system based on this foundation. The MarketPsych trader training coaching programs are built on this process. Please call if we can be of help.

Richard Friesen
RFriesen@MarketPsych.com
(415) 259-0652

Negative Expectations at Their Highest in History

Our MarketPsych index of negative stock market expectations is now the highest we've ever seen (we've got data back to 1984).

The Fed's actions and words -- explicitly committing to bail out mortgage lenders -- should have lowered market negativity. Instead we got a morning rally afterwards and then further selling.

What we saw last week was everyone jumping ship - a real crowd effect. The only information driving investors was downwards price action and rumors of further collapses. The more stocks dropped, the more they sold. A positive feedback loop was created.

In psychology, a positive feedback loop is created when people base their opinion of how bad a situation is on the actions of others. When everyone is doing this, we can usually call it the peak of a mania or the bottom of a panic.

The market stopped being comforted by the Fed, which is a bit scary. Fortunately, it was primarily the financials getting hit today. The Biotech index was actually up 4%. A rally is certainly near (though I was wrong last week).

Eventually, when the supply of sellers decreases, because they've run out of shares or capital to sell, positive feedback loops can't sustain their negative price momentum.

The danger is that acting on negative expectations can become a self-fulfilling prophecy. I wrote about this in my book, with the example of Brazil's near debt default in 2002.

Essentially, the more investors avoid new bond offerings, and the higher rates go (especially for junk bonds), the more squeezed are companies that need to raise capital. Eventually many will go bust because they can't afford the high interest rates (which are high because investors are afraid the companies will default). If the rates had been lower (because investors were more calm), then the debt would have been service-able and the company would have survived. The crowd's pessimism really can make things worse (just as its optimism was problematic in allowing such overconfident risk taking through 2007).

At this point, it's important to ask "can it get worse?" (yes), "will it get worse?" (probably), and "has this been priced in?" (in many sectors, yes, much too much).

In financials it's not clear to me if it has been priced in, hmmm.... A rally in financials won't happen until we know where the next bogeyman is. And right now, there are lots of terrible rumors, but no new sources of pain. I think investors are waiting to see how the current pain will spread, since it's clear that the economy is slowing and the real economic slowdown hasn't been reflected in the numbers yet. "Who's next to collapse?" is often heard.

There are some amazing bargains out there. A stock or bond screen will demonstrate great values. I don't trust the numbers on financials (never have), but in some traditional industries low debt stocks with PEs of 6 and trading under their book values are much more common. I won't get specific because the blog is about psychology, not stocks picks at the moment.

But watch out for stocks vulnerable to the self-fulfilling prophecy of higher interest rates for "risky" bonds. That's whay I mentioned to look for "low debt" stocks.

Solutions to the current crisis include better political and regulatory management of the psychology of risk-taking, which isn't likely anytime soon (as I mentioned in my last blog post). It will take some deep understanding of human behavior in the Fed and SEC (and maybe an in-house psychologist or two) before we get such enlightened policy. In the meantme, there will always be bubbles and panics to take advantage of.

Historic times we're in. Now let's make the best of it!

Richard

Neuroeconomics 2007 -- Happenings at the SFN Annual Conference

As if Boston wasn't brainy enough with 51 colleges and universities (see this list), the annual neuroeconomics conference was held there this past weekend. Excellent new neuroscience research gave the audience's grey matter some delightful brain candy to chew on all weekend. I'll just list a few of the fascinating findings below. There are many more that I will not mention for space reasons.

In an effort to break the conference's three days of presented research down into a bullet-point-speckled summary, I'll organize the studies in the three following categories:
1) How people, on average, make personal financial decisions. Such experiments manipulated conditions of risk, reward, punishment, and ambiguity or uncertainty in order to see what types of brain activity correlate with (or even better, predict), not-mathematically-rational financial decisions.
2) How people make social financial decisions. These are often simulated using strategic games played with others (or computers dressed as others) and are relevant to morality in general. Such decisions affect other people (and usually oneself) financially.
3) How people are different from one another in their financial decisions, especially in regards to the brain activity that leads to their different choices under similar conditions.

Under personal financial decisions, Peter Bossaerts excellent (and intricate) study of traders in a simulated market was one of the most fascinating. He found that excellent trading (in this case, based on "tape reading") did not appear correlated with mathematical ability. Rather, it required a unique ability to understand the minds and intentions of others (variously called "theory of mind" or empathy). His study is far too complicated to explain in more detail here.

Researchers at NYU demonstrated the behavioral (and some neural) consequences of loss aversion in an investment-type task. Interestingly, the NYU researchers asked subjects to view all their upcoming "investments" in terms of a portfolio to see if it reduced their loss aversion (it did, but not entirely). They also found that an individual's level of loss aversion correlated with a greater SCR response (arousal) to losses versus gains.

Researchers from the Soochow and National Yang-Ming Universities of Taiwan, in the Soochow Gambling Task, have continued to demonstrate that people prefer small high frequency gains punctuated by occasional large losses (negative overall expected value) to small losses that are occasionally punctuated by a large gain (positive ooverall expected value), even after they are told the odds and probabilities. See my book for more detail about this remarkable result.

Brian Knutson's group at Stanford found that priming subjects with a sexy photograph increased NAcc activation (in the reward system) and increased their willingess to take risky financial gambles, even though finance has nothing to do with seeing a sexy photo (I presume).

In a study at NYU using one of Paul Glimcher's tasks, adolescents were found to be more "ambiguity seeking" than adults, but more "risk-averse" than adults when they knew the odds of the gamble. Per the researchers, perhaps their drive to learn and explore overcomes an aversion to known risks that they might not be skilled enough to handle yet.

In the second category of studies, Paul Zak's group at Claremont Graduate University found that touch (a massage of Player 2) more than tripled the amount that Player 2s (in the Trust Game) gave back to Player 1s. And the amount of $$ returned was correlated with blood oxytocin levels (especially baseline level). Recall that in the Trust Game, Player 2 isn't obligated to give anything back to Player 1, so this is a pretty profound finding. The Trust Game is described in my book in some detail.

In the third caegory, studies on how people make decisions differently, it is clear that there are observable patterns of brain activation, circuitry, underlying personality styles, and patterns of behavior such as:
1) Intuitive versus reasoning problem-solving,
2) Those who succumb to regret aversion (avoiding organizing their finances, for example) versus those who plan for the future,
3) Impusive versus more deliberate decision makers,
4) Maximizing versus satisficing decision makers, and
5) Machiavellian (primarily self-interested) versus more cooperative decision makers.
The first four results (preliminary) were found by Scott Huettel at Duke University's Center for Neuroecnomic Studies.

Other researchers found that the ability to self-reduce one's level of fear (and one's physiological fear-resonse) was correlated with the thickness of a part of the brain (VMPFC) that inhibits the amygdala and appears to generate soothing thoughts. Also, thickness of the insular cortex correlated with an increased sensitivity to aversive (bad) outcomes.

One interesting mention was of prior studies indicating that one's score on a "Private Body Consciousness Scale" (one's degree of somatic preoccupation) correlates with an increased susceptibility to the placebo effect. Now if one supposes that marketing is in some way activating placebo-effect-type brain circuits (people feeling good about themselves for a product purchase or consuming a branded product, for example), then it might be true that brain activity predicting the placebo effect will also predict whether one believes that higher prices denote higher quality (and better taste). According to Hilke Plassmann at Caltech, they do. That is, people who scored highly on body consciousness, when they drank a wine they was priced higher (but identical) to a lower-priced wine, thought it tasted better (and this finding was correlated with specific neural activation).

Other researchers found that individuals' "risk-aversion" to financial gambles appears to have a broad brain ciruit which governs it and indicates a specific personality type.

I hope this laundry list of findings is interesting and useful for all who could not attend!

Cheers,
Richard

IT'S HERE: Inside the Investor's Brain

After a year-long writing odyssey, it's with great excitement that I announce the release of my new book, Inside the Investor's Brain. You can purchase the book here: Inside the Investor's Brain: The Power of Mind Over Money (Wiley Trading).

The ability to manage your mind in the markets is necessary for long-term trading and investment success. This book teaches the science of achieving high investment returns through an understanding of the power of mind. Endorsements are here. I won't repeat the publishers's long blurb (here: Inside the Investor's Brain: The Power of Mind Over Money (Wiley Trading)), but below is the table of contents:

Introduction.

PART ONE. FOUNDATIONS: THE INTERSECTION OF MIND AND MONEY.
Chapter 1. Markets on the Mind: The challenge of finding an edge.
Chapter 2. Brain Basics: The building blocks.
Chapter 3. Origins of Mind: Expectations, beliefs, and meaning.
Chapter 4. Neurochemistry: This is your brain on drugs.

PART TWO. FEELINGS AND FINANCES.
Chapter 5. Intuition: The power of listening to your gut.
Chapter 6. Money Emotions: Clouding judgment.
Chapter 7. Joy, Hope, and Greed: Hooked on a feeling.
Chapter 8. Overconfidence and Hubris: Too much of a good thing.
Chapter 9. Anxiety, Fear, and Nervousness: How not to panic.
Chapter 10. Stress and burn-out: Short term pleasure, long term pain.
Chapter 11. Love of Risk: Are you trading or gambling?
Chapter 12. Personality Factors: What are great investors like?

PART THREE. THINKING ABOUT MONEY.
Chapter 13. Making Decisions: The effects of probability, ambiguity, and trust.
Chapter 14. Framing Your Options: Seeing the world in black and white.
Chapter 15. Loss Aversion: Cutting losers short and letting winners run.
Chapter 16. Time Discounting: Why we eat dessert first.
Chapter 17. Herding: Keeping up with the Jones’.
Chapter 18. Charting and data mining: Reading tea leaves.
Chapter 19. Attention and Memory: What’s in a name?
Chapter 20. Age, Sex, and Culture: Risk-taking around the world.

PART FOUR. IN PRACTICE.
Chapter 21. Emotion Management: A balancing act.
Chapter 22. Change Techniques: Going deep.
Chapter 23. Behavioral Finance Investing: Playing the players.

Notes.
Glossary.
Index.

It is my sincere hope that Inside the Investor's Brain will help you achieve investment (and life) success beyond your wildest expectations.

Richard