Thursday, February 22, 2007

The Role of Somatic Markers in Trading Decisions

I think this is one of my more important articles: a perspective on trading psychology from the field of cognitive neuroscience.

In past posts, I have emphasized the importance of controlling the body's level of arousal as a fundamental trading skill, because so many psychological disruptions of trading are state-dependent. There are cognitive and behavioral methods for achieving such control; these include simple exercises that traders can perform on their own.

There is far more to trading psychology, however, than simply taming emotions. The idea that emotions are the root of trading problems--and that successful traders eliminate their emotions--is one of the great myths in the field. Indeed, research in cognitive neuroscience--particularly the work pioneered by Antonio Damasio--suggests that emotion is absolutely crucial in decision making.

Damasio's seminal contribution in this area of research is his somatic marker hypothesis. An overview of this hypothesis and relevant research is available in this review article. According to that article, the gist of the somatic marker hypothesis is that:

"Structures in ventromedial prefrontal cortex provide the substrate for learning an association between certain classes of complex situation, on the one hand, and the type of bioregulatory state (including emotional state) usually associated with that class of situation in past individual experience. The ventromedial sector holds linkages between the facts that compose a given situation, and the emotion previously paired with it in an individual's contingent experience. The linkages are ‘dispositional’ in the sense that they do not hold the representation of the facts or of the emotional state explicitly, but hold rather the potential to reactivate an emotion by acting on the appropriate cortical or subcortical structures..."

Let's paraphrase that in plain English! A section of the brain's frontal cortex is responsible for storing and processing associations between situations and the emotions that had been activated by those situations. When we store these associations, we are not storing conscious memories. Instead, we create links between situations and how those situations make us feel. Those linkages are "dispositional", which means that they lead us to act in one way or another.

Here's a simple example: I have many fond memories of spending time in cafes in the U.S. and Europe. If I pass a cafe on the streets of Seattle and smell the aroma of coffee, that perception activates the feeling-states associated with my prior experience. Thanks to those feeling states, I am disposed to enter the cafe and spend some time there. My decision to enter the establishment is not a simple, rational process of toting up pros and cons. Rather, the feeling state mixed with the perception of the cafe--a link embedded in the ventromedial prefrontal cortex--leads to the decision.

So it is with all decisions, Damasio argues. Feelings--from explicit emotions to felt body states--are joined with perceptions to guide our behavior.

The research cited in the review article suggests that, when people experience damage to their ventromedial prefrontal cortex, they are no longer able to make sound decisions. One especially fascinating lines of research involves a risk-taking game that requires decision-making similar to that involved in trading. This "gambling task" involves choosing cards from four decks. Two of the decks have higher payoffs on wins, but also larger penalties for losses, so that the overall returns are negative. Two of the decks have smaller payoffs for wins, but smaller penalties, and an overall positive expectation of gain.

At the start of the gambling task, subjects don't know the odds for the piles. Over time, however, normal subjects learn to prefer the piles with the positive odds for winning. When they are hooked up to biofeedback equipment, they display clear skin conductance responses ahead of making their choices. These stress-related feeling states appear to help guide the choices of piles. Conversely, subjects with damage to their ventromedial prefrontal cortices do not display such anticipatory responses. They lack the feelings that guide good decision-making. As a result, they display a sustained preference for the high-return, high-penalty, negative expectation decks. Without access to their encoded feeling states, they cannot make good decisions under conditions of risk and uncertainty.

Now here's the really interesting part. Normal adults who describe themselves as risk-takers do not have damage to their ventromedial prefrontal cortex regions, but they do display a similar tendency to persistently choose cards from the risky, low-return piles. When connected to biofeedback equipment, the risk-takers *do* display emotional signals prior to making their choices, not unlike the normal subjects. They tend, however, to override those signals with their explicit thought processes. The brain-damaged subjects, on the other hand, never receive the emotional signals from the ventromedial prefrontal cortex in the first place.

The implications for trading are significant. The idea that successful traders overcome or eliminate their emotions is completely off-base. If that were to truly happen, the trader would behave like a brain-damaged patient. Rather, it is the overriding of emotional signals and signals from felt bodily experience that facilitates poor decision-making. This overriding can occur because of anxiety, greed, or myriad cognitive rationalizations. The implication, however, is that--at some level--experienced traders receive valuable physical and emotional signals to guide their decision-making. It is the temporary lack of access to these signals that leads traders to behave like the risk-takers in Damasio's experiments.

In a recent post, I emphasized the value of biofeedback in achieving self control. It may well be, however, that the greatest value of such disciplines as meditation, relaxation training, and biofeedback is to help people maintain a clear mind so that they do not override and obscure the somatic markers that are necessary for sound decision making. I strongly suspect that traders would be better served by disciplines that enable them to be accurate observers of their feelings than prescriptions for squelching those feelings. Choice lies at the heart of trading, and if Damasio is correct, our felt experience is a necessary substrate of choice. The somatic markers are there; it's simply a matter of keeping our access open to them, even as we're surrounded by risk, reward, and uncertainty.