Wednesday, November 02, 2005

The Psychology of the Housing Bubble

I was getting my hair cut yesterday, and the guy next to me was talking loudly about his upcoming weekend. He had chartered a private jet to take his girlfriend to Idaho for the weekend. This guy must have been in his mid-20s. He went on to explain that he'd been working in real estate for "a long time". He was having "a great run". He explained to the hairdresser that anyone could get into real estate, even without savings - "there is this great financing you can get", he told her with self-confidence.

Pundits talk a lot these days about the housing bubble. Excellent articles in The Economist ("After the fall", Jun 16th 2005) and The New York Times ("Is It Better to Buy or Rent?", Sep 25th 2005) demonstrate how real estate fundamentals cannot support current prices. Real estate in the coastal regions of the United States (particularly San Francisco, Boston, Los Angeles, New York, and Miami) and Europe (southern Spain) is overvalued and vulnerable to future price declines. Prices have been driven to these levels by fancy financing schemes, hopes of rapid capital appreciation, and the fear that "if I don't get in now, when will I ever?"

I got interested in financial bubbles during medical school, when the Nasdaq was soaring high with the internet mania. In fact, my "senior project" in medical school was to research the psychology of stock market bubbles. My faculty supervisor, Ernest Barratt, is the creator of eponymous "Barratt Impulsiveness Scale" - a widely used impulsivity measure. It turns out that impulsiveness (among other psychological traits) is directly related to how easily we are pulled into the "bubble mentality".

The recent price appreciation of real estate represents "irrational exuberance". But that'e easy for many people to identify. The hard part is timing an entry and exit, and knowing what the consequences of a deflating bubble will be for other industries.

To call the peak of a bubble, you've got to know what will deflate that exuberance (and prevent it from reflating). And you've got to understand how a bubble forms. But let's back up a for a minute. From a psychological perspective, how do we even know when we're in a bubble?

Bubbles usually start with good intentions. The internet stock bubble is an easy example. The internet is changing the world. But all those changes did not occur from 1997 through 1999.

People generally over-react when they get a string of good news. They start thinking, "the sky's the limit." And that's when the warning bells should go off. I've got a list of bubble prerequisites below. The financial fundamentals are often easy to measure. It's when the expectations of future returns, or the hope for short-term capital gain, inflate that we have to worry.

Below is a diagnostic chart to help understand when a bubble might form, whether in real estate, an entire industry, or an individual stock.


Low supply. Examples include:
The scarcity of homes in certain regions of the coasts
Stricter development regulations
Little or vague financial information available:
It is difficult to gauge market price changes
Realtors have an incentive to hide a softening market
Excess liquidity in the pockets of buyers
Low interest rates (and then interest-only loan payments)
Large capital gains have already been reaped by the "first-movers", and they're looking for new opportunities.

Vividness of the concept
"I've got to have a roof over my head"
"I like real estate because you can see what you own"
Limited supply (Perception of scarcity)
"No more houses can be built on the coasts due to development restrictions"
Water-cooler or media frenzy: Groupthink and herding.
"You know, everybody's buying a house. Are you still a renter?"
Anticipatory emotions and impulsivity
Excitement about "getting rich" and fear of missing out.
Magnitude of potential payoff
"My friend made $300,000 after owning her house only one year."
Certainty of payoff
"Real estate has always gone up over any 5 year period. I'll just hold a few years if I have to."
"You've got to get in now, since you don't know how long you'll be able to afford property around here"
Pursuit of gain (chasing)
Seminars on "How to get rich in real estate".
"It's proven, the surest way to wealth is real estate"

Now how do we know when the end is near?

Any stagnation or reversal in previously positive financial fundamentals paired with:
1) Historically high volume of turnover (already happening)
2) Positive expectations are disappointed in some investors (already happening)
3) Sellers begin dropping prices or relisting with other brokers (already happening)
4) Intense media focus (already happening) - but ironically, this is usually favorable coverage of the bubble - with real estate it has been unfavorable.

If you have any ideas or additions, please feel free to add them in the "comments" section below.


Wednesday, October 12, 2005

What Are Your Financial Values?

How are the wealthy different from everyone else? The wealthy have realized that money won't solve all their problems. (Appeared in Forbes Magazine several years ago)

There are many widely held misperceptions about wealth and the effects of wealth on people who have it. Yet the personal struggles of the wealthy are very similar to those of most people, with a few notable exceptions.

Wealth allows people to think beyond the next mortgage payment or credit card bill. It allows thinking about the pursuit of unfulfilled dreams, how to value and prioritize free time, the effects of past losses on our financial values today, and our legacy for the next generations. Issues that are very personal.

The way each one of us addresses such issues says a lot about who we are. In many cases, few of us think deeply about such issues until we retire from our careers. To have more fulfilling lives, it is important to understand ourselves as early as possible.

I've recently created a new psychological assessment for people with accumulated assets or who are nearing (or are in) retirement. But the test can be taken by everyone, regardless of wealth level. It's called the "Financial Values Questionnaire".

This questionnaire was designed for two purposes:
1) I wanted to help people understand their beliefs, values, and personality tendencies when dealing with money.
2) There is an increasing interest among financial advisors to establish more personal relationships with their clients, by understanding their unique financial psychology.
The Financial Values Quesionnaire was designed with both of the above in mind.

The "Financial Values Questionnaire", on the website, will help you think about the purpose and meaning of money in your life. Do you accumulate money to fund your goals and dreams? Does money play any role in your legacy to future generations? Are you excessively hesitant due to past losses? Where do you get a sense of purpose or meaning in your life? These are the types of issues addressed in the questionnaire.

I'm pasting some of the actual questions, and some of the answers submitted so far, in the space below. Your answers on the test are anonymous (we don't know who wrote them) and confidential (we have tight security). The test registration process does not require identifying information to be given. The test is currently FREE, is 59 questions, requires 15 minutes to take, and you get both the basic and detailed reports for nothing (free). (In 2006 we will start charging $$ to take it, so now is a good time to take it if you're ever going to).

I hope you enjoy reading these unedited responses from several test-takers on questions 52 and 58. Users' responses follow the "A: ":

Q: 52. What traditions and values in your family are important and should be carried on?
A: Life and love first, then money.
A: Money
A: Individual liberty and independence
A: That God Is one. And we have been created for his worship. And at the time of death to have had the intention to worship him.
A: education and belief in God
A: Family holidays spent together. Family the most important unity in our lives.
A: Family values, to be happy, spend your money wisley... save
A: People should be self-sufficient and obediate to God, respect themselves and others.
A: Family parties
A: leaving family money
A: FAmily comes first
A: Caring for each other, our future summer home.
A: care for each other, life a life where you use your talents and to serve others

Q: 58. How would you like to be remembered by later generations?
A: as someone who never gave up
A: For the good that I've done.
A: successful
A: i haven't decided.
A: that by remberance of me they will remember the Worship of God.
A: as a hero
A: As a happy and outgoing person
A: generous, honest and helpful.
A: A very fun, energetic, respectable person
A: I'd like to be remembered as someone who gave insight, integrity and value to others.
A: good person
A: fun
A: Loving, caring, and giving individual
A: Loving and generous
A: generous
A: no idea
A: as one who did not hold on to assets but who freely shared time, talents and love with others

You can take the test here: Financial Values Test Registration

Best wishes,

Wednesday, September 21, 2005

Neuroeconomics 2005

This past weekend was the 4-day "Neuroeconomics 2005" conference on Kiawah Island, South Carolina. "Neuroeconomics" is the study of how people make decisions about things they value (or should value). One example is how people evaluate and trade stocks. Other examples include games that measure financial trust, honesty and cooperation, strategic decision making and asset allocation, and risk preferences. This conference is a largely academic affair with research presentations by neuroscience, psychology, and economics researchers throughout each day.

Attendees were largely professors and graduate students, though a few pracitioners such as Jason Zweig (Money Magazine), Arnold Wood (Martingale Asset Management), Shirley Mueller (Star Financial), and myself were also present.

I'm unable to report on details of the latest "neurofinance" research until it appears in publication. The Stanford researchers (Kuhnen and Knutson -- see post below) have additional data from their study, and researchers at Baylor College of Medicine (especially Terry Lohrenz) are doing a fascinating asset market experiment with fMRI. Lohrenz is a former energy trader and mathematician.

In general, it was a very enjoyable meeting. Some of the findings will be described in later posts as they are published.


Thursday, September 01, 2005

Greed and Fear sabotage investors in a Stanford study

"We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful."
~Warren Buffet

A recent neuroimaging study from researchers at Stanford University reveals the brain origins and expensive consequences of emotions experienced during financial decision making. Graduate student Camelia Kuhnen (School of Business) and professor Brian Knutson (Psychology Department) performed brain imaging on Stanford graduate students while they engaged in an investment decision making task. They report on this study in a paper entitled “The Neural Basis of Financial Risk-Taking” (2005), published in the journal Neuron v47, n5 on September 1, 2005. This is the first study to monitor subcortical brain activity during an investment decision-making experiment.

The experimenters used functional magnetic resonance imaging (fMRI) to examine brain function. FMRI allows researchers to measure changes in brain activity over short time intervals (2 seconds) in small regions of the brain (2 cubic millimeters). Changes in brain activity are indicated by alterations in regional metabolism, tissue oxygen usage, and blood flow.

In their experimental task, called the Behavioral Investment Allocation Strategy (BIAS) task, Kuhnen and Knutson asked subjects to make an investment choice between three alternatives. Two of the alternatives were risky “stocks” (either "Stock A" or "Stock B"), one with a net positive payoff over the 10 trials, and the other with a net negative payoff over the ten trials. At the beginning of each block of 10 trials, subjects did not know which stock was profitable or which was money losing. The "good" stock had a payoff of +$10 (50%), $0 (25%), and -$10 (25%), for an expected value per trial of $2.50. While the "bad" stock had payoffs of +$10 (25%), $0 (25%), and -$10 (50%), for an expected value per trial of -$2.50. A third choice was a bond which yielded a constant return of $1 per trial.

Potential Choice Payoffs:
Bond = $1 per trial
Stock A = Averaged either +$2.50 or -$2.50 per trial.
Stock B = Averaged either +$2.50 or -$2.50 per trial.

While the goal of this task is to make as much money as possible, subjects can't know which stock is the high paying one until after the task has begun. Subjects made "irrational" stock choices when they did not maximize their profits (e.g., they chose a bond even though fairly certain of which is the high-paying stock).

Dear reader, try to decide how you would choose in this experiment. Would you start out choosing a stock? If not, how would you proceed? After how many trials would you know with some certainty which was the high-payoff stock? [Do this quickly before reading on].

While laying on their backs in the MRI scanner, subjects were allotted 12 seconds per trial, with 10 trials per block. For each trial:
1. Subjects would see the three options appear on a computer screen for 2 seconds (Stock A, Stock B, and Bond),
2. followed by a 2 second delay during which they were asked to make a choice,
3. then another 2 second delay interval,
4. then a report of the outcome of their choice 2 seconds,
5. then a report of the outcomes of all the possible choices for 2 seconds,
6. then a 2 second delay until the next trial.
Each of the trials lasted 12 seconds total. There were 20 blocks of 10 trials each. Subjects were encouraged to try to make as much money as possible.

After learning progressing through several the trials, one should optimally begin to choose the "good" stock when 70% certain of its identity. Of course, most of us don’t know Bayes theorem by heart. Truth be told, few readers have heard of Bayes theorem. And if you're an investor, and you actually use it, you're a rare breed.

The true genius of this paper lies in how the researchers analyzed the data they had obtained. They found that subjects tended to make irrational decisions, and that two areas of the brain, strongly linked to the experience of the emotions excitement and fear, were activated just before irrational decisions were made.

Subjects would occasionally choose the bond after the experiment was well underway and they should have had adequate experience to choose the right stock. In the situation where the subjects had adequate information about the stocks to make a profitable decision, but they chose the bond anyway, they were making a "risk-aversion" mistake. Activation in an area of the brain called the anterior insula was correlated with risk-aversion errors (see image below). This image is from one of our unpublished studies on expected utility.

Anterior insula activation occurs when we are experiencing pain, anxiety, or disgust. After choosing one of the stocks, and losing, subjects felt pain about their loss and anxiety about losing again. Following such as loss, they were more likely to choose the safety of the bond, thus making a "risk-aversion mistake". This is a similar result to that in the "brain-damaged investors" study described in a previous blog post where, immediately following a loss, 20% fewer subjects accepted a subsequent gamble of the same, postive, odds.

When subjects in the experiment took too much risk, a different area of the brain was activated. Subjects who chose one of the stocks before the odds were known to be in their favor had higher activation of an area of the brain called the nucleus accumbens (see image below):

The nucleus accumbens is famous for several interesting characteristics:
1. The Pleasure Center. Rats with a wire placed in the nucleus accumbens would press a lever, to electrically stimulate themselves, repeatedly until they collapsed from exhaustion or died (Olds and Milner, 1954). Neurosurgeons found that people reported intense sensations of well-being (and some had orgasms) when stimulated in the nucleus accumbens. More recently, Knutson et al (2001) demonstrated that nucleus accumbens activation is linearly correlated with subjective reports of positive emotionality.
2. Dope and Drug Abuse. All drugs of abuse activate dopamine neurons in the mesolimbic dopamine circuit, which has terminals in the nucleus accumbens.
3. Reward Anticipation. The nucleus accumbens is activated on fMRI scans when people are anticipating or expecting to make money (Knutson et al, 2001) as well as other satisfying rewards.

Kuhnen and Knutson demonstrated that insula activation predicts errors of risk-aversion, and nucleus accumbens activation predicts errors of risk-seeking. Because the insula and nucleus accumbens generate emotions, their activations give rise to feelings. We can use our physical and emotional feelings as signals to indicate when we are likely to make errors in our investment decision making.

In most areas of life, feelings are necessary for making good decisions. For examples, see Malcolm Gladwell's new book Blink (2005). We need to feel in order to have an intuitive sense of which decisions are likely to be successful and which are likely to be damaging.

According to the press release: "On average, the participants in the study made rational choices 75 percent of the time and made mistakes 25 percent of the time, Knutson said. And the brain areas lit up even when rational choices were being made, just not as much. " This implies that emotions are part of both rational and irrational choice behavior. It's the extremes of emotion that lead to irrationality.

Per the press release: "These findings may also explain why casinos employ "reward cues" such as free drinks and surprise gifts as anticipation of other rewards that may activate the NAcc and lead to changes in behavior, Knutson added. Insurance companies might employ the opposite strategy, using strategies that would activate the anterior insula, he said."

Danger arises when feelings are either excessive or misattributed. Intense feelings such as greed and fear lead to the risk-aversion and risk-seeking mistakes seen in the Kuhnen and Knutson study. Misplaced feelings are attributed to incorrect causes. Being given small gifts by a casino may "prime" the reward system and put us in a risk-seeking state of mind. Viewing scenes of recent hurricane destruction prompts fears of other possible catastrophes and makes us risk-averse.

Investors should be careful to not let such biases affect their decision discipline. They can monitor their decisions to notice how they may be biased by recent experiences. "The bigger message may be a common-sense one: Whenever you're facing a big decision, step back a moment and think it over."

In particular, if a person has experienced a recent loss and notes that he or she is feeling nervous and is exhibiting other signs of irrational risk avoidance behavior such as 1) hesitation in entering new positions, 2) deliberating about further potential losses, or 3) seeing more financial threats than usual, then he or she must take special care to not let that increase in anxiety affect future discipline in trading decisions. Conversely, if a financial market participant has recently made large gains and is feeling 1) celebratory, 2) extremely intelligent, and 3) wants to let his position ride, then he or she must make sure not to focus solely upon potential returns and ignore the risk control and monitoring aspects required by his or her trading discipline when making future decisions.

The following paper is a summary of techniques investors can use to identify when their decisions may be biased by damaging emotions:
Top Ten Tips from the Neuroscience of Investing
My own homepage is here: Richard L. Peterson M.D.

Tuesday, August 16, 2005

Sunshine and the stock market

"Sunshine on my shoulders makes me happy
.... Sunshine almost always makes me high"
~ John Denver, "Sunshine on my shoulders"

On sunny days we feel good - that's a recurring theme in music, poetry, and literature. When we feel good, whether because of sunshine or some other factor, does that change how we deal with risk? Some enterprising researchers have asked that question and come up with fascinating findings. They discovered that on sunny days the stock market tends to go up.

See this quote from Hirshleifer and Shumway's 2001 working paper called "Good Day Sunshine: Stock Returns and the Weather". This paper was later published in the 2003 Journal of Finance:
The magnitude of the sunshine effect is substantial. For example, in New York City, the annualized nominal market return on perfectly sunny days is approximately 24.8% per year versus 8.7% per year on perfectly cloudy days.

I've created a daily updated sunshine index. See the full story here. More emotion-related indicators will be posted in the future. Sunshine is just the beginning of the story.


Monday, August 08, 2005

The Jackpot Trap: The Danger of Big Wins Early

You can choose your expression: "A rising tide lifts all boats", "Never confuse brains for a bull market"... one of my favorites is "When the tide goes out, then we'll see who's been swimmin' nekked".

A Texan told me that one.

These aphorisms are all a variation of an investing truism: favorable market conditions tend to provide good returns for investors regardless of their skill levels.

In the late 90's we saw many of these "success" stories. In 1999 it seemed you couldn't open a major newspaper without encountering an article on day traders and the remarkable returns they were achieving. The message was seductive. "Easy money", they'd say. "Work from home! "C'mon everybody's doing it..." It was enough to tempt the most austere of investors into leaving that 9-5 job.

But the market is a stormy sea. And that seductive call of the trading firms (and their media accomplices) turned out to be a siren's song leading investors onto the rocks like so many helpless sailors. Portfolios were shattered. Lives were changed forever.

Hidden in these "rags to riches to rags" stories is a quirky and counterintuitive phenomenon -- the relationship between big wins early in a gambling career and subsequent pathological gambling.

It is more common than not for a pathological gambler (I'm talking about the type of gambler who ruins his/her life, not merely people who have a weakness for Vegas) to have a huge windfall in the first year of his/her career (typically 1/3 to 1/2 of a year's income).

This comes as a surprise to many people. How can a big win be a bad thing?

Well, for many people it isn't. But for a subset of the population it is the equivalent of the bait that springs a life-ruining trap. The problem plays out on several levels.

1) You can't get a big return quickly without a big risk, so the behavior is usually remarkably reckless.

2) People cite the windfall as evidence of their brilliance. (After all, they picked those stocks!)

3) When people experience that rush in the infancy of their investing/gambling career it acts as a formative experience. Though the odds of hitting such a jackpot are roughly the same as David Hasselhoff sweeping the Oscars, it is VERY difficult to let go of the notion that it will happen again.

What seems like a blessing becomes a curse.

The take-away is two fold.

1) Should you be fortunate enough to get huge returns on early trades in your career, put it in its proper perspective and recognize the risk that accompanies your success.

2) The other is beware "wunderkind" money managers who generate huge returns in their first year. The people the media tout as the "next big thing" are often precisely the sort of investor you should look out for. It may well be that they are simply budding Peter Lynches or Bill Millers, but neophyte money managers who generate returns well beyond what could be reasonably expected are also high risk for the Jackpot Trap. Do your homework before they lure you in.

Take the quick and confidential Marketpsych Gambling screen (second test on page) if you think you might have a problem.

Wednesday, July 27, 2005

Once Burned, Twice Shy: Do brain-damaged traders really have an advantage over the rest of us?

When I first started trading, I made a lot of mistakes. After I'd made pretty much every mistake known to man, I started repeating them. It was pretty ugly for a while. At one point I realized that everyone else was committing the same errors, over and over, and there was a certain logic to it. The article below identifies the logic of one of those "hardwired" mistakes.

I first became acquainted with this investing mistake when I was trading off some market-forecasting software I'd developed. It seeemed like pretty sophisticated software at the time, but whenever I had a loss, I began to doubt it's efficacy. After a particularly brutal loss (like when I was long S&P futures during Alan Greenspan's "Irrational Exuberance" speech in 1996), I'd sit out the market for the next few days "to take a break". And it ALWAYS seemed that by sitting out the market, I'd miss the best trades of the year. We have a tendency to sit out the market after losses. It's an emotion-driven error, and we need to be especially careful about avoiding it.

A somewhat misleading Wall Street Journal article: "Lessons from the Brain-Damaged Investor" July 21, 2005 discusses research on people with a unique type of frontal brain-damage. The study was published in June's Psychological Science. In the study, people with a focal type of brain lesion, eliminating their ability to "feel" emotions, were pitted against "normals" in a gambling game.

In this experiment each participant was given $20 to start. Then they had the option of gambling or abstaining over twenty rounds of coin flips. If they chose to gamble, they would win $3.50 if the coin toss landed on heads or lose $1 if it came up tails. If they chose to abstain, then they made $1 automatically. The expected value of the gamble was $1.25, so you might assume that most subjects took the gamble.

Sure enough, normals took the gamble at an average rate of 68%, and brain-damaged subjects took it 78% of the time. After a loss, brain-damaged subjects took the gamble at the same rate (about 80%), but normals dropped to taking the gamble only 47% of the time. Because of a recent loss, normals became "irrationally risk-avoidant." So you might imagine, "there's a brain area that sabotages my investing."

This isn't quite true. It turns out that these brain damaged individuals can have pretty miserable lives - maxing out their credit cards, not showing up to work on time, falling for internet scams. Even though most of them score normally on psychological tests, there is clearly something wrong with their judgment. They can't seem to recognize the downside of risk, the possibility of loss. So they aren't necessarily an example of good investors. But there is something to be learned here.

The more relevant story, for most of us, is that we tend to avoid financial risk after a recent loss. Risk avoidance is pretty smart after most types of losses - that's how we learn from mistakes. For example, if the executives of a company you are invested in are caught "cooking the books", leading to a nasty price decline, then you might be more wary and do more due diligence before investing in a similar company. That caution is a good thing, because that's how we learn to avoid unhealthy risk.

The same type of avoidance happens among traders after personal losses, such as illnesses, broken relationships, or job changes. Traders may unexpectedly find themselves hesitant and with "difficulty pulling the trigger" when thinking about trades.

Problems often arise when we learn from "mistakes" that were actually random events. If we mistakenly believe that our investment results are due to factors within our control, then we may compulsively re-examine our strategies after losses, potentially leading to "analysis paralysis."

Recent losses make us afraid of taking on more risk. If we avoid the stock market entirely because we got burned by a few internet stocks, then we're not being rational, and we're missing out on higher returns down the road. Maybe this is why bear markets drag on, leaders talk about a "crisis of confidence", and most investors wait for price "confirmation" before jumping back in. Of course, waiting for confirmation means missing much of the price move, but that's the cost we're willing to pay for enhanced confidence.

What are the take-aways? After a loss, be careful that you don't over-analyze. if your strategy is well thought-out and tested, you've got nothing to worry about. Most likely, it was just random events taking place.


Friday, July 15, 2005

Here's a few predictions of which you can be equally confident:

1) The sun will rise tomorrow morning.

2) The Tampa Bay Devil Rays will fail spectacularly in their bid to win the 2005 World Series.

3) The return for individual investors in 2005 will be worse than the advertised returns for the funds in which they invest.

In other words, if at the end of the year a fund claims a 14% return, you can be certain that the actual return for the average investor will be less than that.

The Wall Street Journal, (7-13-05, "Fund Investors Gain by Sitting Tight", by Jane Kim) once again explains this unfortunate investing phenomenon, something I call "Whack-A-Mole Syndrome". It is the dominant paradigm of today's investor, as predictable as it is insidious.

Why does this happen? In short, because human emotions confound our buy/sell decisions. When we see a fund move higher, it becomes safer, more attractive. We buy in. When a fund slumps, we tend to feel uneasy and move our money elsewhere. The problem is that this pattern virtually assures that we will buy on the peaks and sell in the valleys.

Many 401 K plans unwittingly contribute to the problem. They ditch the funds that are underperforming (gotta get rid of those dogs!) and move to "hot funds" that are a lot easier to defend to the bosses and the employees.

Whack-A-Mole by proxy.

This recently happened to me. I checked an old retirement account with a former employer to find all new holdings and my balance inexplicably lower. I called the HR department. The exchange went something like this

Frank: "What happened to my funds?"

HR Guy: "We rotated out of those funds."

Frank: "Whyja do that?

HR Guy: "They were underperforming."

Frank: "Ah. I see... well thank goodness for that!"

HR Guy (Apparently immune to New York sarcasm): "Our pleasure, sir."

So how do you combat this monster in your accounts? The WSJ article gives some simple advice supported by data: Hold onto them longer. The longer an investor has the fund, the closer their return will be to the advertised return.

There's an old expression: All roads lead to Rome. Well in the investing world the expression would be, "most roads lead to wealth". The problem isn't that people get on the wrong road. We just have this awful tendency to wander off them.

Keep that in mind next time you feel like "taking a short cut".

Monday, July 11, 2005

Aspiring to Trading Greatness

What makes a great trader? In the 1983 movie "Trading Places," Eddie Murphy (a wily street con-artist) and Dan Akroyd (an ivy-league heir and investor) had their identities reversed by two wagering millionaires. Could Eddie Murphy, with no prior experience, succeed in the trading pits? Could Dan Akroyd pull himself out of forced homelessness with nothing but his own smarts? The comedic pair ultimately outwitted their interlopers and made a killing in "Frozen Orange Juice" futures. Yet the question those two devious millionaires gambled on remains unsolved, is it innate skill or life experience that makes a trader great?

Occasionally we work with traders. Sometimes we help them get out of a "slump". Sometimes they're already good, and we help them become great. Because of the high level of interest in what makes traders great, and the large amount of really poor information on the subject, I'm posting a list of the characteristics of great traders.

This list is a compilation of the results of academic research into the elements of trading success. Since these are academic studies, the results aren't necessary simple to understand, but it's the closest thing we've got to help us emulate the minds, if not the strategies, of great traders.

CLICK HERE for the trading success factors.


Thursday, June 30, 2005

Neurofinance Is What?

I'm often asked questions of the sort, "What are the tangible, practical applications of neurofinance?"

Quick answer:
1. Helping people make better financial decisions.
2. Finding and exploiting irrationalities in the financial and business markets.

Expanded answer:
1. Diagnosing individual differences in financial decision making (e.g. looking at who is better and worse at certain financial scenarios, and why (it's in the brain)). Then customizing biological and psychological interventions to improve their decisions.
2. Looking at what type of information activates people's hardwired neural circuitry (e.g. what makes them more or less risk averse?). Then examining how that shared group processing affects financial and business markets (e.g. guides the search for financial market anomalies).
3. Discovering how people's unconscious neural states predict their behavior. Then looking at what activates different neural states (e.g. sunshine makes dopamine release increase in the brain's neurons, subsequently we feel happy, and the stock market goes up since we become less risk averse when happy and dopamine-infused).

Longest answer:
The question "What is neurofinance?" is arguable. "Neurofinance" sounds good - the word connotes the cutting-edge - something technological, futuristic, and potentially lucrative. But in its way, "neurofinance" is 'all hat and no cattle' (as my Texan relatives might say) - the word looks slick but doesn't have any obvious scientific backing.

In general, neurofinance refers to neuroscience and psychology studies of traders, investors, and pretty much anyone who is making financial decisions. You may wonder, "have there been many of these studies?" Good question. The answer is sadly no, not at all.

If you look through the body of scientific research and published data regarding neuroscience and economics, you won't find any studies with directly commercializable results.

Given the potential profits to be derived for any business that can understand the mechanisms (and errors) of financial decision making, you might feel incredulous that very little research has been done in this vein.

Part of the reason for this ommission lies in the fact that finance researchers have only recently (within the past 15 years) stopped arguing about whether individual irrationalities are reflected in market prices or in important business decisions. Now that we have stopped arguing and accepted that YES they are there, the fields of behavioral finance and behavioral economics have moved into the mainstream in business schools. Now that we all agree there might be something useful for finance through an understanding of psychology, who's going to do the research?

Many researchers have been stymied by the lengthy learning curve required to master the new neural research technologies such as positron emission tomography (PET), functional magnetic resonance imaging (fMRI), electroencephalography (EEG), and psychophysiological techniques. Studies of patients with specific neural lesions are similarly difficult to organize.

Searching for the origins of rational and irrational financial decisions often requires interdisciplinary research between finance, psychology, and/or medical researchers. When we aggregate subjects and look at general trends in their behavior, we do find that most people, on average, make specific financial errors over and over again - these are presumed to be inescapably hardwired (neurally-based) mistakes. This blog will discuss these errors (a.k.a. cognitive and emotional biases or heuristics), and what you can do to prevent and manage them, in later postings.

Andrew Lo and Dmitry Repin at MIT have published the most relevant data regarding neurofinance. They studied the physiology of traders (The Psychophysiology of Real-Time Financial Risk Processing). They found that periods of market volatility cause physiological reactions (increased cardiac volume and skin conductance), especially in less experienced traders. Physiological reactions indicate that adrenaline and other stress hormones and proteins have been released by the nervous system. To simplify, traders are stressed out by market volatility. "Big deal," you may say, "I already knew that."

Lo and Repin then found, in a second study, that the most emotionally reactive traders have the worst trading results. Intriguingly, they also found that traders with the least emotional reactivity also have diminished results. Moderate emotionality is optimal for successful trading.

Every other good study in the field of "neurofinance" is under review for publication. Some interesting correlations can be drawn from among other research, but the sum total of the pure neurofinance studies published so far are the two by Lo and Repin, and those studies don't even look at brain activations.

A study that should be coming out soon does look at brain activations using fMRI, and it's results are stunning. Stay tuned for its publication, hopefully this Fall.

In future posts I'll discuss some of the latest research in neuroimaging and how it relates to trading, investing, and saavy money management. For more info, check out:


Wednesday, June 22, 2005


When talking to new clients in the financial industry, we often get the question, "Why should I care about financial psychology?" Once we answer that question we typically hear, "What can I do to improve myself and my team?" And then we occasionally hear, "How do I make money with this stuff?"

This blog answers all three questions.

Academics study investor psychology under the guise of various fields of research: behavioral finance, personality psychology, cognitive science, neuroeconomics, affective neuroscience, and many others. We're here to simplify, focus, and condense the research into something relevant and useful. We aim to save you money and make you more successful in your business.

Our postings will be organized into general topics such as:
1. Psychological biases
2. Your financial personality
3. Important recent research
4. A psychological spin on current financial happenings
5. The neuroscience of money
6. Market anomalies
to name a few...

We're hoping this site helps you live a happier, healthier, and more financially comfortable life.

Best Wishes,
Richard Peterson MD
Frank Murtha PhD