Saturday, August 18, 2007

Mood, Emotion, and Trading

Before I launch into the topic of this post, allow me to note that this is the 1000th post to TraderFeed, a number I could have never envisioned when I first started the blog. To put that into perspective, if someone were to post to a site twice a week every week out of the year, it would take almost 10 years to generate a comparable output. Amazing how much work we can do when it doesn't feel like work!

Today's topic is mood. The psychological research, nicely summarized by William Morris in his chapter "The Mood System" in the book Well-Being: The Foundations of Hedonic Psychology, emphasizes that mood is not the same as emotion. Moods are more transient feeling states: a person who has high well-being can experience bad moods, just as depressed people can enjoy occasional good moods. Moods have a surprisingly strong impact upon our functioning, which makes them relevant for performance disciplines such as trading.

The first impact of mood is on memory. When we are in good moods, we tend to form positive memories and inhibit the formation of bad ones. Bad moods, on the other hand, interfere with the creation of good memories, but do not necessarily facilitate negative ones. This has implications for behavior, since our recall may help guide future decisions. In one study cited by Morris, subjects led to feel good rated the performance of their cars and TV sets more highly than subjects not exposed to mood manipulations. This would conceivably impact their future purchasing decisions. Similarly, a trader in a good mood might put a positive spin on his or her performance, leading to an enhanced willingness to assume risk.

Mood also affects our judgment and perception. When presented with positive and negative information, subjects in a good mood will rate the positive news as more informative. Subjects in a negative mood are more likely to rate positive and negative news as equally informative. It's not difficult to see how this could lead traders in positive moods to bias their information processing about stocks and the positions they hold.

In one of my favorite studies, subjects were asked about their satisfaction with life. When asked on rainy, cloudy days, subjects gave more negative ratings than when asked on sunny days. This effect vanished, however, when the experimenter brought the weather to the explicit attention of the subjects. The implication is that subtle factors can affect both mood and perception, but that becoming aware of biases can help us avoid their impact.

Morris' central point is that mood accomplishes a kind of self-regulation, controlling our behavior across a range of situations. When people have negative moods, they tend to focus inward and withdraw from activity. In positive moods, people become more invested in the world around them and more actively engaged. When we perceive that we can adequately meet the demands of the environment, we experience positive mood; when we lack such a perception, the result is negative mood.

"Mood solves a problem for us by providing continuous monitoring of the availability of resources necessary for meeting current demands," Morris emphasizes (p. 181). Mood facilitates action when we perceive that such action will be effectual; it inhibits action when we don't perceive an ability to meet external demands.

In that sense, mood is very different from our more enduring emotional experiences of happiness and satisfaction with life. Mood is a real-time monitoring system for adapting our motivational states to our relationship with our environment. To draw upon an imperfect analogy: emotion is like climate; mood is like temperature.

This has two important implications for traders:

1) Mood Can Have Biasing Effects - Even unnoticed, subtle factors such as the weather can impact perception, judgment, and decision making. This could lead us to be overconfident or underconfident in trading situations. By making efforts to notice our moods and reflect on their sources, we can minimize such bias. In my next post, I will suggest a simple mood checklist that can help traders quickly identify their mood states.

2) Mood Can Provide Information - Moods aren't necessarily something to simply "get over". They are providing us with real time data regarding our ability to meet the challenges of markets. When we experience a bad mood, our minds and bodies are telling us that we're not perceiving that we have the resources needed to make money. Such signals often will occur at points in which market regimes and patterns are changing. This can keep us out of danger, but can also energize us when we see markets fall into line with our research and preparation.

A worthwhile activity for a trading journal is to track P/L (and other trading metrics) as a function of mood during the trading day. I've learned to recognize moods that are pure poison to my own trading and routinely take time away from the screen when those occur. Chief among these is a confused mood. If I feel as though I can't get a handle on what's going on, it's become a great signal for me to stay out of the water until I have a better sense of things. That simple step has saved me considerable money during the recent market turbulence.


Inside the Trader's Brain: Emotion and Decision Making

Overconfidence and Underconfidence: Biases in Processing Emotion in Trading