Here’s a quick, informal personality test. Among the following pairs of options, which would you prefer?
1. a) Eating at a favorite restaurant; b) Eating at a new, exotic restaurant.
2) a) Relaxing at home after work; b) Going to a lively party after work.
3) a) Driving a reliable sedan; b) Driving a sports car.
4) a) Avoiding recreational drug use; b) Trying recreational drugs.
5) a) Vacationing in the mountains; b) Climbing a mountain with friends.
If you gravitated toward the b) selections, you exhibit a trait that psychologists refer to as “sensation-seeking“. People who are sensation seekers tend to like novelty and adventure and quickly become bored by routines.
So what does this have to do with financial markets? It turns out that a large body of psychological research finds that people who are sensation seekers tend to also be risk takers. Indeed, many hapless traders are attracted to markets precisely because of the stimulation of risk and reward. At the extreme, this makes trading an addiction, not a disciplined quest to exploit market inefficiencies.
Cognitive neuroscience researchers suggest that much of risk-taking may be hard-wired, controlled by specific brain regions. Indeed, much of the risk-taking commonly associated with adolescence can be traced to changes in the brain during that developmental period. Similarly, brain differences have been linked to the impulsive, risk-seeking behaviors of psychopaths.
Could it be that some people are hard-wired from birth to seek sensation and risk? We see this most clearly among children who exhibit attention deficits and hyperactivity: most often they also display impulsivity and sensation-seeking from an early age, making them particularly prone to antisocial behavior. Longitudinal developmental research supports the idea that temperaments–which include the traits of activity and distractibility– appear at a very early stage of development and remain remarkably stable across the lifespan.
It is easy to see how tendencies toward activity, distractibility, sensation-seeking, and risk-taking could undermine market participants and doom them to failure. A few years ago, I wrote a post noting that markets were rigged against human nature, as short-term returns following strong periods reliably underperformed those following weak periods. (This mean reversion has been tracked admirably by the MarketSci blog). If traders, eager for stimulation and risk, impulsively jump aboard directional market moves, they would systematically underperform market averages.
Successful trading requires the ability to take meaningful risk, but also the capacity for controlling that risk. One can trade for sensation and one can trade for profits, but rarely can one do both.