Research in behavioral finance suggests that participants in financial markets are not fully rational actors. Instead, they tend to act upon cognitive biases and emotional reactions that slant their estimates of risk and influence their perceptions of financial data.
In a study that I conducted with Andrew Lo and Dmitry Repin of MIT, we found that emotional reactivity to financial markets was correlated with trading performance. Specifically, “…subjects whose emotional reactions to gains and losses were more intense on the positive and negative side exhibited significantly worse trading performance, implying a negative correlation between successful trading behavior and emotional reactivity” (p. 352).
In that study, we found, no single set of personality traits was significantly correlated with favorable trading outcomes. Rather, it was emotional reactivity overall that seemed to best predict profitability.
These results would seem to support the common perception that success in financial markets requires an elimination of emotion from trading decisions. A corollary of this view is that all good trading must be rationally conceived, planned, and executed: that good traders are those, as the saying goes, that “plan their trades and trade their plans.”
The problem with this perspective is that it does not fit the realities of trading floors at the firms where I work as a psychologist and coach. Traders, even the most successful, are often highly emotional and competitive. Many sustain significant profitability year after year trading actively each day, holding positions for mere minutes. Invariably these very active traders have no time to research their trades, not to mention develop formal trading plans.
Research into implicit learning suggests that people routinely apprehend complex patterns in the world without necessarily being able to verbalize those patterns. For instance, young children can form grammatically correct sentences and yet cannot explain the rules of grammar. Very active traders develop a “feel” for markets that enables them to act on short-term shifts in momentum without being able to formally lay out the rationale underlying their trades.
Antonio Damasio’s research suggests that such implicit learning is cued by “somatic markers“: a felt sense of fit or non-fit when we perceive patterns in the world. Such markers, for instance, may cue us to shift topics in a conversation when we sense that the other party is uncomfortable. We may not be able to verbalize the reasons for the shift at the time–it occurs spontaneously in the flow of interaction–but we know it feels right in the context of discourse.
Very active traders describe a similar feel for what they do. A market will be weak and suddenly the trader will perceive that “we’re having trouble going lower.” Quickly he enters bids into the order book, gets filled, and rides a reversal move higher. Asked what made him think we were putting in a bottom, the trader simply replies, “They just couldn’t break ’em.”
Damasio’s contention is that the feel that accompanies implicit learning is indeed a kind of feeling: emotion is an integral part of decision making. What makes emotional arousal detrimental to trading is not that emotion necessarily biases decision making, but that it can cover over the more subtle, felt somatic markers that alert us to subtle market patterns. When we are frustrated with our profits and losses, we can no longer fully attend to what feels right when we process complex market relationships. That leaves us out of sync with the market’s conversations.
In Lo and Repin’s study, ten experienced traders were connected to biofeedback equipment while they viewed financial markets. Interestingly, all recorded significant physiological changes during such trading events as breakouts from price ranges. “Contrary to the common belief that emotions have no place in rational financial decision-making processes,” the authors explain, “physiological variables associated with the ANS [autonomic nervous system] exhibit significant changes during market events even for highly experienced professional traders” (p. 332).
The intriguing implication of this work is that those who have immersed themselves in financial markets probably know far more than they know they know. Their performance crucially hinges, not on brushing emotion aside, but in sustaining access to those implicit cues that literally embody expertise.