Friday, September 14, 2007

How Hot Heads Make Cool Decisions

An alert reader passed along this article regarding a study of emotions among investors. Unfortunately, the headline of the article--written, no doubt, to attract readers--indicates that "hot-headed investors make better decisions". Only by reading the article text do we find out that this is a four-week simulation (more like trading than investing) and that the actual finding is that, "those who experienced their feelings with greater intensity during decision-making achieved higher decision-making performance."

According to the article, "The conventional wisdom that emotions can make you irrational has less to do with how intense your feelings are than with how much you understand them...those investors who listened to their emotions were better able to regulate them."

In other words, the better decision-makers were not less emotional; they were better equipped to experience, acknowledge, and understand their feelings. Note how this very much fits with the theme of my post yesterday.

The takeaway, I believe, is that all of us have two information processing channels working simultaneously. We process the world explicitly, in an analytical mode, even as we process events implicitly via feeling. Our explicit, analytical channel tells us about the qualities of events and entities that we encounter; our implicit, emotional channel informs us about the self-relevance of those events and entities--whether they pose opportunity, threat, etc.

It's as if we have two antennae: One reaches out and asks, "What is this?" and the other feels around for, "What does this mean for me?"

Both provide information.

Much of our daily life is a delicate interweaving of these modes; our antennae work in concert. Thus, when we're in a conversation, we're processing the logical content of what our partner is saying, but we're also feeling its relevance for us.

When traders shut off emotion--or use action or avoidance to keep feelings out of awareness--it's as if they disable one of their antennae. The result is a loss of information. The study cited by the reader finds that awareness of emotion--utilizing the information from that feeling antenna--aids decision making.

Of course, if one becomes so submerged in the emotional state that it overwhelms the other, rational information-processing mode, the results are also disabling.

Feelings are data: the key is what we do with that information. Many times, we will know what to do if we just allow ourselves to fully acknowledge and experience what we're feeling. A trader I recently worked with was quite frightened when volatility exploded in his market. He didn't like the anxiety, but it told him that things weren't right. He used that information to cut his size and wait for his opportunities. While others at his firm lost significant money, he actually added a bit to his year's results.

The general rule is: When we violate our trading rules and good trading practice, it's often because we're avoiding an emotional experience. We're not honoring our stop loss points because we want to avoid feelings of loss, inadequacy, and failure. We're overtrading because we want to avoid feelings of boredom or confusion about what the market is doing. If we can make friends with the emotions we're avoiding, all those bad practices go out the window. They no longer serve a defensive function.


Bridging the Gap Between Hot and Cold Emotional States

Why Traders Self-Sabotage

Psychological Risk Management