A few moments ago, CNBC broadcast a weather report showing the best and worst case scenarios for the potential left and right track of Hurricane Earl. They projected it will “brush the East Coast on Thursday”. Weather channels, however, are saying “Friday” is the H-day. Who’s right?

There is literally no way to know – until it happens. And they have better data and models than any trader or quant on the planet. With markets, a flash crash or its cousin – the hedge fund implosion – can literally occur at any moment. A hurricane, on the other hand, will never take a sudden turn to the left or right…. never!

Why does this matter to market players? It matters because the human brain implicitly knows the difference between solving an algebra problem for X, predicting a hurricane and markets. In the latter two are successively higher levels of uncertainty and the brain is going to use context to make judgment calls about how to react.  Furthermore, a big part of that context is going to be in the realm of subjective level of beliefs regarding possible outcomes – some in NYC may say we haven’t seen a hurricane in years and some are going to be ordering from Fresh Direct for Wednesday delivery (me!). Why the difference? Beliefs basically … most will assume the recent past tells the future (the recency bias in behavioral finance). I on the other hand, as a consultant in better risk thinking, am trained to think about the risks others don’t notice. Having a very full fridge is a mild price to pay if the winds and rains become a real deterrent to going outside.

The point is that all market and trading models and plans need to explicitly leave room for judgment – judgment that also externalizes beliefs and confidence levels. Every model is uncertain – whether it be for Uncle Earl or for implied volatility. Getting comfortable with that up-front and NOT when you have to make a decision will serve your portfolio, your trades and your fridge quite well.

UPDATE -

30 hours later … and only two days from NYC and the forecast is LESS certain not more. Meteorological models now are showing a front moving in from Chicago that /could/ pull the storm westward and onto the NE coastline of the US.

Quiz – do we know more or less about Earl than we know about the markets? The Dow was up 250 or so points today…. what does that mean (besides bonds took the downward slope).

Two new terms you will (eventually) read in this book I am feverishly working on. (It’s true – I am having a blast and really want nothing else but to be able to work on it… hence, my choice of the word feverishly): “Travesting” – meaning the combination of trading and investing that everyone needs to be undertaking in order to manage their own portfolios and by extension their own futures and “fC” for the feelings context in which we make all of our decisions but certainly the reality with which we make “risk” decisions.

Others that might be new -

Emotion Analytics – internal and external – as risk management and strategy inputs.

Emotional Architectures – the basic reactionary/perceptual explanations we bring to any situation – both conscious and unconscious.

In our society’s positive thinking zeitgeist, we overlook the power of so-called negative emotions. Frustration for example – if examined – often clarifies a problem and a solution.

First however one needs to be able to tolerate the feeling. Second they need to put it into words that truly and satisfyingly describe it.

The temptation here is to oversimplify it by blaming the feeling on someone or something. Not that other people failing to do what we want or need isn’t often the cause but more that getting the other people to do what you want isn’t necessarily the answer – although it is the one that most easily springs to mind.

I find over and over again that doing the emotion analytics – and taking into consideration my own emotional architecture – turns frustration into progress.

The market meltdowns of last few years spawned an interest in the research and theoretical field of Behavioral Finance that simply didn’t exist before. Books like THINK TWICE, Harnessing the Power of Counter-Intuition garner great attention and great crowds for Michael Mauboussin the author. Calls to our office for talks, interviews or articles on “Irrationality” likewise keep on coming.

A void still exists though. While the observations of Behavioral Economics prove that “smart” isn’t enough, those same observations don’t go far enough to explain really why we tend to make bad choices with probability or what we can really do about it. From my point of view, we need to understand why we do what we do before we can change it.

And to that end, there still exists an old idea about our brain. In fact, exists isn’t the word for it. Simply put the out-dated thinking dictates that feelings and emotions emanate from our old brain and remain inferior to our cognitive, logical reasoning and analytical capabilities. In psychology schools you will hear this referred to as cleverly as System 1 (cold rational) or System 2 (hot emotional). You will also hear reflective and reactive as synonyms for the supposed systems 1 and 2.

But this frankly is proving to be a mis-understanding or put another way, simply another grossly popular bad assumption. Research shows we can’t make decisions without having feelings associated with those decisions. In trading the feeling that gets talked about all the time is confidence. Confidence, or alternatively conviction, applies to decisions about model factors, decisions to invest (confidence in viewpoint on why a stock will go up) and just about every other decision that has overt risk in it.

What is confidence or conviction? Is it a thought? Think about it – it is time to ReThink Thinking®.

Lisa Feldman Barrett of Boston College argues cogently for the idea of one integrated system. She has lots of support in the literature.

Our best thinking will make all of the feelings and emotions that surrounding our thoughts explicit – and will in turn then give us a qualitative overlay on our quantitative risk analyses that will create much more fully informed choices about risk.

Now Dr. Elise Payzan Le Nestour is about to begin her professorship in Finance at The Australian School of Business but she has graciously taken the time to summarize the findings from her recent research.

“(My) research shows that under certain conditions, investors can cope with the instability encountered in financial markets very well. Specifically, they can seize arbitrage opportunities in contexts where a hitherto-good asset can become very bad all of a sudden — this is what financial economists call “regime shifts.” In such labile contexts, investors would do well to detect the shifts. As it turns out, people can do that very well, despite the complexity of the enterprise.

Such capacity is however very fragile: investors need to be aware of the phenomenon of shifts for them to detect the shifts. When they are initially naive to the phenomenon (because nobody alerted then about its occurrence), learning vanishes: people don’t perceive the unstable assets as unstable, and their learning becomes delusional. This is because our mental models assume stationarity: we a priori think that things have a permanent value; the thought that things are unstable is not natural to us.

The key insight of this research is therefore that investors can be extremely efficient decision makers, albeit not “naturally”. It is critical that they build awareness about the nature of uncertainty in their environment in a first stage. This is a very positive message, which contrasts with standard behavioral finance which says people are stupid.”

We love her work ( here and at TP) because it has something very important to say – if you are on the lookout for uncertainty (which we try to teach all of our clients HOW to be) – you have a much better of chance of more accurate perceptions of change. Her research game was all about detecting change – and really, in our opinion, that is what risk management should focus on. In reality, many people tend to do the opposite – keep looking for “the same”.

…everything we think, feel and do is related to this. ReThinking Thinking is about analyzing these evolving contexts – and understanding that thinking is hardly just about “smarts” – that is where we go wrong. …. Wrong in risk management, wrong in analyses and definitely wrong in perceptions.

As long as we do not know what caused the flash crash, why isn’t sabotage on the table? Or, is it on the table and we don’t know it.

I mean are we looking at the obvious and overlooking what we don’t want to see? Why would P&G, MMM and Accenture have relatively more erratic reactions than the rest of the market?

Between the avalanche of neuroimages, the financial crisis and its aftermath and Jonah Lehrer’s book entitled How We Decide, interest in figuring out the answer has probably never been so attenuated.

Allow me to submit a new model that I will believe will come to be the way we understand our own decision making come 10 years or so from now.

Picture a triangle with its three points labeled rational, social and emotional. Or try an infinity symbol in which these same three “dimensions” are inexorably intertwined. In other words, at least as far back as Descartes in the 1600’s and of course further back to Socrates we have tended to elevate the rational to a place above the social and emotional but ironically, if anything, it is the other way around!

To quote some the best game theorists and neuroeconomists in the world “It is not enough to know what should be done, one must also feel it.” (Camerer, Lowenstein and Prelec, Journal of Economic Literature, March 2005). Simply invert that phrase “one must feel it, to know what should be done” and you have the missing link to understanding all decision making.

Feelings however are not so simple a topic are they? At the level of our day to day experience, many if not most of our feelings have a very relevant social context to them. In other words, doing well at work, wondering about how our spouse feels about something we have done, going to the dinner party because ‘we should’ …. all have a substantial social expectation or social judgment element that should be understood. We could go on but I challenge you to find a feeling that does NOT have a social expectation (yours or others) to it.

Recent research goes so far as to suggest that maybe it is the development of a social brain that made us human – and in fact differentiates us the most from our ape cousins.

Stay tuned…. As usual… with ReThinking Thinking …. to be continued.

DKS

We like to believe we make well-analyzed, rational decisions. We consciously evaluate data, massage statistics and assign weights to the pros and cons of what we think are potential outcomes. Yet time and time again, we realize in hindsight that we didn’t make a rational decision – buying that stock near the top, investing in the vacation house in 2008 or leaving our spouse for someone seemingly so much more interesting… all have a way of looking downright stupid a few years or even months down the road.

We tell ourselves “I will never do that again”. We vow to be more objective and less swayed by our emotions.

And the beat goes on.

Could it be that maybe our whole approach to making judgment calls is based on faulty assumptions? It sure seems that way when Harvard can put 70 portfolio managers in a room and over the course of two days even these professionals in probability fail the group exercises over and over and over.

How about we take a step back and reconsider the substrate of decisions altogether? I submit to you that while we believe we are thinking analytically we are really working within a social and emotional context that skews our field of vision in the same way those fun house glasses at the carnival do.

Within markets, research shows that traders who understand the  market as a social game do better. Even in probability tests, research shows that people who understand the problem in terms of humans instead of in terms of numbers will most likely deduce the correct answer more quickly and more often.

Likewise, it is very easy to predict decisions if one understands that residual emotion from previous results colors the way one sees a new problem. (In practicality this looks like what would have been a good idea yesterday, seems like the right thing to do now).

This social emotional context is the thesis of the book that sooner or later I will finish. In the meantime, I ask you to at least give the idea some thought – maybe our logically analytical numerically based thinking isn’t the creme de la creme.

No matter where I go, no matter who calls, no matter when I check twitter… there it is – “behavioral finance”. In an effort to understand the great financial crisis of 2008 everyone it seems has turned to what the academics call the “biases and heuristics lit”. I mean it seems so ubiquitous to me (granted I am biased that I swear I even hear about it in Starbucks and on the 6 train in Manhattan.

Yet beyond the platitudes, how many people can really do anything but list and define the ostensible biases? Again, I am definitely and completely without a doubt biased but I do listen very carefully for someone to make these experimental observations both explicable and practical … and so far…

I even attended Harvard’s annual conference on the said topic and while it was great and I feel lucky to have had the opportunity, the “why” of the matter (at least in my not so humble opinion) still needs attention.

So hence, this ReThink Group now exists and hopefully soon we will fully articulate what we have spoken about at US Trust, Morgan Stanley, BNY Mellon and Battle of the Quants in a book called RISKY BUSINESS: IT ISN’T WHAT YOUR BRAIN THINKS!