Tuesday, September 11, 2007

Making Sound Financial Decisions Under Conditions of Fear

I recently received a call from a Wall St Journal reporter asking good questions regarding the role of fear in trading and investment decisions. This topic is particularly relevant, given recent market volatility.

As this excellent summary indicates, a wealth of research finds that people make suboptimal decisions under conditions of high emotional arousal. Different regions of the brain are responsible for decision-making under high vs. low risk conditions. Excessive activity in these centers for processing emotions leads to either excessive risk-taking or excessive risk aversion.

Similarly, distortion of information due to how decisions are framed is mediated by activity in the amgydala, which is implicated in our processing of emotional stresses.

Quite simply, our brains function differently under conditions of fear (and greed!) than under cooler emotional conditions. As a result, we can make decisions with our money that later (in our more calm modes) seem puzzling to us.

How can we minimize such distortions in our decision-making? One simple way is to clearly articulate the rationale behind each of our investment or trading decisions. Specifically, we want to map out:

1) Why we are making this decision; what we expect to happen; why we think that current prices are away from true value;

2) What would lead us to take profits; what would be fair value that would lead us to exit the position;

3) What would lead us to exit the position if it goes against us; what would tell us that we are wrong in our initial assumptions.

In many performance fields, such as Special Forces military training, people are taught to follow decision-making routines under highly stressful conditions. By making these routines explicit and repeating them to the point of internalization, we make it easier to access them even when the blood flows in our brain are activating our flight or fight responses.

Reducing trading and investment decisions to a few criteria and then mentally rehearsing those--keeping them explicit--is a great way to stay grounded during periods of uncertainty and volatility. The goal is to make the same decisions under conditions of pressure that you would make in calm conditions. Mentally rehearsing various pressured ("what if") scenarios and walking yourself through the steps you'd take in each situation is excellent preparation for real-time risk.


Handling Volatile Markets: Lessons From Neuroeconomics

Inside the Trader's Brain