Tuesday, November 18, 2008

Stress and Performance in Trading

An excellent review of research by Mark Staal, conducted for NASA, offers fascinating windows on the variety of ways that stress can affect human performance. Examining hundreds of research studies, the author finds that stress interferes with attention, memory, decision making, and perceptual motor performance. His review questions the common notion that people perform better under moderate loads of stress than under very low or very high levels. Rather, in many spheres, there is an inverse linear relationship between experienced stress and performance.

The behavioral finance literature suggests that one reason stress might affect performance among traders is by skewing their assessments of risk and reward. Under pressure, traders may narrow their cognitive scope to only the information most salient to them (availability bias) or relevant to their expectations (confirmation bias); focus only on superficial qualities of observations (representativeness heuristic); or become more likely to take profits than losses (disposition effect). In other words, stress disrupts performance by altering normal, sound information processing.

In a unique study, Lo and Repin found that veteran traders are less likely to experience the physiological effects of stress in response to market events than novice traders. A reasonable interpretation of the results is that, through repeated experience, traders learn to psychologically normalize the stresses associated with the risks, rewards, and uncertainties of financial markets. Directed training, in which traders rehearse sound decision making under particularly stressful market conditions, could greatly accelerate a trader's learning curve. Indeed, this is a model of training central to the development of many professionals in performance fields, from military special forces to the surgical sub-specialties.

A major flaw of much trader education is that it is not applied under conditions of stress, and so cannot train the trader to perform flawlessly in the heat of battle.