Sunday, July 27, 2014

Trading and Our Emotional Temperament

One of the more interesting findings in the positive psychology research literature is that happiness is more related to the frequency of positive feelings than their intensity.  Occasional feelings of intense joy are less important to our overall happiness than frequent positive experience.

Related to this finding is the important observation that positive and negative emotion--while negatively correlated in the short run--are largely independent of one another over longer time frames.  This is due, in part, to the intensity dimension.  People can have frequent positive experiences amidst occasional intense negative experiences and vice versa.  During highly emotional periods, positive and negative emotion are strongly negatively correlated.  Over longer periods and ones of more modest intensity, positive feelings are recalled relatively independent of negative ones.

Indeed, if we think of positive and negative emotion as independent, we can define four temperaments:  1) happy (high positive/low negative); 2) distressed (low positive/high negative); 3) volatile (high positive/high negative); and 4) stable (low positive/low negative).  An interesting hypothesis is that these temperaments impact how people view markets and trading.  We commonly think that successful trading is a function of controlling one's emotions, as in the fourth category above.  Might it be the case, however, that successful traders find constructive ways to engage markets within their particular temperaments?

A good example would be the distressed category above.  Traders who worry about their positions and focus on what could go wrong in their trades might be successful by tightly managing risk and achieving superior risk-adjusted returns.  That would be different from more volatile, risk-taking traders, who sacrifice Sharpe ratio to achieve superior absolute returns.

Even on shorter time scales, might traders experience varying mixtures of positive and negative emotions throughout the day and week?  Once we adopt the scientific temperament described above and treat positive and negative emotions as separate, independent experiences, then we can ask interesting questions about the types of events that lead us to feel positively or negatively.  We can also track performance as a function of the two states and examine whether, say, increases in market or P/L volatility correlate with increases in the volatility of both positive and negative emotions.

Given that temperament impacts emotion, attention, and activity, it is surprising that we know so little about how temperament is related to performance success.  We would think, for example, that very outgoing people with loads of positive emotion would make good salespeople.  In fact, the opposite appears to be the case:  those with moderate temperament tend to do the best at sales.  Interestingly, something similar appears to be at work among traders:  a study I conducted with Andrew Lo and Dmitry Repin with traders studying with Linda Raschke found that high levels of emotional reactivity were associated with worse trading performance.  Personality traits did not predict performance, but the intensity of emotionality during trading did--in a negative way.  It didn't matter whether the emotion was positive or negative: intensity of experience was disruptive of performance.

Still, the research of Lo and Repin suggests that emotions do play an important role in trading decisions.  Even experienced traders, hooked up to biofeedback units while trading, display patterns of emotional arousal in the context of their trading.  That research also found, however, that experienced traders displayed less intense emotional reactivity than inexperienced traders.  Once again, we see an important distinction between emotional intensity and frequency.  Perhaps one valuable aspect of training and experience is that they enable us to dampen the intensity of our emotional reactions within whatever temperament we might have.  Once we've been there, done that, it's easier to not overreact to situations.   

We gravitate toward particular trading approaches for many reasons:  our cognitive strengths, personality traits, and emotional temperament all likely play a role in determining whether we seek success as systems traders, investors, daytraders, or active portfolio managers.  Ultimately, our trading reflects who we are and either generates emotional experiences that suit or frustrate our temperaments.  That fit of trading experience and personal temperament may well be an important mediator of sustained trading success. 

Further Reading:  Peyton Manning and the Heart of Peak Performance