Wednesday, October 25, 2006

Inside The Trader's Brain: Decision-Making and Emotional Arousal

For years, behavioral finance researchers have been aware that people's decision making is greatly affected by how choices are framed. For instance, the same monetary bet framed as a choice between a certain vs. risky gain and a certain vs. risky loss elicits very different choices. (We tend to take certain gains, but will seek risky losses to avoid certain loss). Studies using functional magnetic resonance imaging (fMRI) find that we expend less cognitive effort in taking a sure gain than in choosing risky gains, sure losses, or risky losses. It may well be that traders don't let their profits run simply because they take the easy way out cognitively. Conversely, traders may be reluctant to set and follow stops because of the greater cognitive effort required.

It turns out, however, that this taking the easy way out and avoiding difficult decisions may not be a function of laziness. A very interesting investigation coming out of the Institute of Neurology at University College London finds that the framing effect on decision making is mediated by an emotional center within the brain: the amygdala. This is the same brain center that cognitive neuroscientist Joseph LeDoux has linked to our response to stress and trauma.

The implications are significant. When blood flow is directed away from the brain's executive center, the frontal cortex, and the amygdala and associated emotional centers are activated, we are likely to underutilize those executive functions--reasoning, judgment, planning--and respond to our (emotional) framing of choices with a lack of effort. Going with our feelings might just be the reason we don't think through our choices.

It is also likely that we frame our choices differently during periods of focus/concentration vs. emotional arousal. Stressful episodes in the market, activating the amygdala, are likely to elicit a framing that is different from the careful trade planning we conduct when we are cool and calm. Research, for instance, finds that fear and anger color our decision making about preparing for terrorism-related risks. Emotional factors have also been found to color decision making about economic choices.

This helps to explain why I have found biofeedback to be extraordinarily helpful for traders who experience emotional disruptions of decision making. By working with traders in stressful situations and having them control their level of arousal during these episodes, biofeedback enables them to retain access to their executive capabilities. In a very important sense, successful traders train their brains for accurate decision-making under stressful circumstances.

Sometimes, looking back on our trading decisions, we wonder if we were in our right minds. How accurate that concern turns out to be! Some of the best trading psychology interventions are the ones that keep us in our right minds as we make decisions under conditions of risk and uncertainty.