Saturday, December 13, 2014

The Two Brains of Trading: Toward a New View of Trading Performance

I propose that there are two primary ways in which traders engage markets:  via the intellectual functions of the brain and via the social functions of the brain.  This distinction underlies the differences we see between traders who are primarily quantitative and systematic versus those who are more qualitative and discretionary.

When a trader engages markets intellectually, decisions about buying and selling are made empirically based upon observed relationships.  Growing revenues and promising new product development at a company may lead to higher expectations for earnings and a higher price multiple, leading an equity manager to place the company on the buy list.  The decision is governed by a model that links inputs (revenues, profit margins, expenses, contributions of new product areas) to outputs (price-earnings multiples, target prices).  When operating in the intellectual mode, the trader is looking at current pricing relative to historical norms, finding a discrepancy, and placing trades that exploit this discrepancy (mispricing).  The intellectual mode thus involves considerable analysis and research.

When a trader engages markets socially, decisions about buying and selling are made qualitatively, based upon the perceived intentions and anticipated behaviors of other market participants.  For example, if I see--going into year end--that positioning is stretched in a number of markets and I know that traders will be reluctant to lose too much money in December because of year-end bonus conventions, I might anticipate greater than normal volatility in the stretched markets.  That could lead to a profitable options trade.  The trade is predicated on a situational theory of the behavior of market participants, not a historically generalizable theory about market volatility.  The social mode thus involves considerable synthesis of information about markets and market participants.

The social brain hypothesis suggests that the brain has evolved in size and function as our social networks have expanded.  From this perspective, the brain is as much a social organ as an intellectual one, with distinct brain centers coordinating knowledge of our own minds and knowledge of those of others.  In his excellent book A User's Guide to the Brain, John Ratey explains, "...traditional psychologists and neurologists have been slow to acknowledge that social behavior is, at least in part, a brain function just like memory or language...Neurologists and neuroscientists have shown that damage to the cortex can affect one's ability to be empathetic, that problems in the cerebellum can cause autism and its social ineptness, and that deficits in the right hemisphere can make it difficult to understand life's overall picture.  Together, these parts and others make up the social brain" (p. 296).

Having worked with many traders and portfolio managers, my observation is that the very skilled ones have either:  a) very developed intellectual capacities; b) very developed social capacities; or c) a very developed integration of the two.  The first we see among world-class systems traders and those with keen analytical frameworks; the second we see among short-term traders who can read order flow and sentiment and anticipate the behavior of "the herd"; and the third we see among skilled portfolio managers who factor logical and psychological factors into their idea generation.

A great example of the latter recently showed up in a meeting I had with a manager who explained the anticipated action of the Fed in coming months based upon an analysis of incoming data.  He then referenced the internal dynamics of the Fed and the relationships among the members and explained how the group was likely to process the incoming data.  It was apparent that he displayed a level of expertise regarding the central bank in terms of the logical and psychological factors at work in its decisions.

This perspective suggests that brain function--and cognitive strengths--may be more important than personality in determining trading success.  It also suggests that understanding and playing to our cognitive strengths may be particularly important in guiding our own trading success.  I suspect many traders fail at the kind of trading they're doing, not because they lack emotional control or discipline, but because they are not wired for the cognitive demands of that particular approach to markets.

Further Reading:  Inside the Trader's Brain