Sunday, September 23, 2007

The Limits of Behavioral Finance and Neuroeconomics

The field of behavioral finance, which studies how subjective elements introduce distortions in decision-making (and presumably inefficiencies in markets), has been successful in broadening ideas in finance based upon assumptions of investor rationality. More recently, the boom in cognitive neuroscience and wider access to imaging has led to a study of brain processes during financial decisions. Variously termed neurofinance and neuroeconomics, these studies have literally enabled us to get inside our own heads to see what happens under conditions of risk and reward.

Two excellent books have recently hit the market to integrate findings within behavioral finance and neuroeconomics. Both are worthy additions to a trader's bookshelf; after reading them, one cannot help but be impressed with the complexity of decision-making and the ways in which we can stray from rationality. For myself as a psychologist and trader, both books also brought more clearly into focus the limitations of these two fields of study.

Inside the Investor's Brain by Richard Peterson is written primarily for an audience of traders and investors. It is well grounded in research and summarizes a variety of themes in the literature, including how emotions affect judgments and various thought-traps that influence financial decisions. He explores the relationship between gambling and financial decision making, illustrating how we typically respond to risk. He also takes a look at how personality shapes our decisions, including the influence of overconfidence, anxiety, and herding. A final section explores techniques for emotion management and several change techniques. The book is very well written and organized.

Your Money and Your Brain by Jason Zweig is aimed more toward a popular reading audience. It is written in an engaging, easy-to-read style, moving swiftly from research studies to everyday examples of skewed decision-making and behavior and back again. Focused more on neuroeconomics than the broad sweep of behavioral finance, the book is organized by emotional themes: greed, confidence, risk, fear, surprise, regret, and happiness. The author effectively illustrates his points, bringing life and human interest to what could be dry laboratory research.

Having surveyed the fields through these two volumes, I cannot help but notice several limits to our current understanding:

1) The Pendulum Has Swung Too Far - The studies emphasize how we depart from rationality, but don't really explain how it is that we do manage to cope in most challenging life situations. Particularly missing are sophisticated accounts of how reflective reason and reflexive emotion work in concert to help us navigate the world successfully. (Damasio's work, for instance, doesn't figure prominently in these accounts, and the large psychological literature on emotion and coping is almost completely absent). As a result, we seem to have gone from a model of investor rationality to one of investor irrationality. But markets *are* efficient, if not perfectly so, and a thorough account of investor and trader behavior needs to account for that fact.

2) Absence of Real-World Validation - For such a large literature, it is noteworthy that so few studies have been conducted with actual traders in actual trading situations. Either the studies create laboratory decision-making tasks or rely on animal models of choice under various conditions. Interestingly, I can't find any studies where the investigators have simply observed traders in the act of trading and interviewed them about their experience or measured their emotional/physiological response patterns. It's all a bit like studying creativity without observing and talking with artists. As a result, some of the conclusions of the research don't ring true to trading life. For instance, there is a presumption that emotions interfere with good decision-making and need, somehow, to be managed. That fails to account for the important ways in which successful traders and investors do manage to profit from their "feel" for markets.

3) Simplistic Portrayal of the Process of Decision Making - Just about every discussion I run into conflates physiological arousal and subjective emotional experience. The two are not the same, and the relationship between the two is an important mediator of coping and performance. At times intuition is described as a function of the body; at times it is equated with emotional feelings. Howard Gardner's important work on multiple intelligences makes room for "bodily-kinesthetic" knowing: the kind of expertise demonstrated by, say, a mime or a dancer. This is different both from reflective/analytic thought and from emotional awareness. That has yet to be integrated into the literatures of neuroeconomics and behavioral finance.

A little while ago, I announced a trader coaching project in which I offered a month of free coaching to a trader in return for the right to post the process to the blog. That work with the trader I called Trader C went well and leads me to consider extending the project. One way of doing so would be to offer free coaching to traders willing to participate in interviews and biofeedback measurement regarding their decision-making experience. Such a project extension would bring needed real-world perspective to a growing and promising literature.

More on what such a project might look like will be coming in October.


Neurofinance and the Assessment of Trader Performance

Handling Volatile Markets: Lessons From Neuroeconomics

Inside the Trader's Brain

Research From Dr. Andrew Lo

Is Trading Style Hard-Wired?