Bridging the Gap Between Hot and Cold Cognitive States

Behavioral finance researchers observe that our perception, judgment, and decision making in cold cognitive states--those in which we are reasoning analytically--tend to be different than when we're in hot, emotional states. Specifically, we are very poor at predicting our behavior under hot conditions when we're cold. Under the hot influence of emotions such as fear, frustration, and excitement, we tend to be greater risk takers, with very different behavioral preferences.

This slide show from the MIT Sloan School of Management nicely illustrates the dilemma we face of being two different people depending upon our emotional states. One of the conclusions drawn by the research is that self-control problems result from our inability to predict and control our behavior under hot conditions when we're cold.

This is also a major challenge for traders of the financial markets. We tend to make our plans and work on ourselves when we're in a relatively calm, cold state. Under the hot conditions of risk and uncertainty, however, we are apt to behave quite differently.

For this reason, I question the value of simple talk-coaching as a means of changing behavior. If the state you're in when you're working on problems is very different from the state you're in when you engage in problematic behavior, the carry over is likely to be minimal.

A better approach is to use structured, guided imagery to recreate hot situations and then mentally rehearse desired thoughts and behaviors under those conditions. The more vivid the scenarios--the more they evoke hot responses--the more likely it is that rehearsed behaviors will carry over into real time.

It may well be that this technique works because it trains people to activate their "cold" systems precisely when those are likely to be suppressed. If this is the case, it may be possible to minimize some of the biases of "motivated reasoning" when tracking markets--our tendency to perceive and reach conclusions in support of our pre-existing preferences.

In my next post on the trader coaching project, I will illustrate the use of this method.

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