Here are the links to my thoughts on the needed new paradigm in risk management (All About Alpha) and the three things anyone can do to be more successful in the financial markets.

What were they thinking? From MF to LTCM

3 Things anyone can do better to understand the psychological side of the markets - the first blog post in Psychology Today’s new blog Market Mind Games

Risk ain’t what it used to be – if fact, most of the time it isn’t even risk at all. Instead it is something called Knightian Uncertainty – or the fundamental inability of humans to know for sure what will happen tomorrow. Yet we have to make decisions about tomorrow all the time.

Reams have been written in the last decade about how we decide but the truth is we’ve still only got a map that /maybe/ is the equivalent of a 19th century world map. And I specifically say maybe because there is so much we know that we don’t know.

Having said that, there are a startling number of things we are learning that turn the conventional wisdom upside down.

1. Context is everything. Even something as definitive as 2+2 = 4 is technically influenced by context. (Depending on the first language you learned, your brain will process that arithmetic differently).

2. Most of our thinking happens below or beyond our awareness – i.e. in our unconscious minds.

3. We have to have emotion to make any kind of decision at all – so trying to set it aside actually hurts us because in effect we are purposely choosing to ignore what may be the most important factor.

And that’s just the beginning.

So think about the implications – for leadership, for tough choices, for markets and for life in general. We literally need to rethink thinking itself – a task I offer a strategy for in MARKET MIND GAMES.

Jon Corzine, who those of us who watch markets have watched as he moved from Goldman to the Senate to being defeated for Governor and now being defeated – reportedly by his own doing – as CEO of MF Global, evidently made a series of very bad decisions. Now Corzine is a smart man with market experience so why?

If Nobel Laureate Daniel Kahneman is to be believed, Corzine was probably thinking “fast” and not “slow”. He acted on his intuition about what European markets would do and then when that went bad, possibly allowed some sort of panicked-driven cover-up. (Without rushing to judgment, they do say it is always the cover-up don’t they?)

But does this concept of thinking fast or thinking slow and the characters of the brain’s ostensible “system 1″ and “system 2″ really explain it?

First, all decisions require emotion. This is an indisputable scientific fact. So to deconstruct any decision, the question is what emotions was Corzine feeling when he made or authorized was now seem to be very regrettable decisions. The easy answer for most people will be “greed” but that gets us exactly nowhere. What’s missing from the “rational man” model of decisions is the reality of regret – or the worry or perception of future regret. In market decisions this turns into a burning fear of missing out. In trading cases, this makes the idea of “reversion to the mean” (or things are just too cheap), way too appealing.

When that doesn’t work, it makes, “well if I get out now I will take a big loss and it will come back” way too compelling. In disaster scenarios, it turns into, “I just need to buy time“.

But here’s the secret, if the emotion involved was routinely reviewed as relevant data then Corzine or anyone else will be less compelled to take action driven by it. Totally revamping emotions as data allows for the evaluation of alternative emotions like “what if I am wrong“. And that is the only way to get out ahead of any concept or fact of our brain’s ostensible “system 1″ and “system 2″

…and no it doesn’t say “PDA” although it may be that “it” is also all about that too.

I am talking – PERCEPTION, JUDGMENT, DECISION & ACTION – the sequence we all go through all the time. It is the sequence that we all want to improve in order to make better decisions and create better outcomes. It doesn’t matter if we are a manager, a money-manager an athlete or the CEO of a Pro-Football team. We all want:

1) More accurate perception

2) Better judgment

3) Decisions that take the right risks

4) Actions that embody those decisions in a way and time that further our objectives.

And guess what? MOST of what goes into this PJDA is … uh-oh… unconscious. So, how are we supposed to get better at each step if in most cases we don’t even know what is influencing each step? That seems impossible.

It’s not.

Brain research shows that feelings and emotions – conscious and unconscious – occur at and within every step. This means that all you really have to do is resolve to become aware of what your feelings and emotions are. Ultimately, you will find that you can learn the difference between an intuitive feeling (experiential learning and unconscious pattern recognition) and an impulsive one (one driven by emotional goals unrelated to the present situation, problem or people).

It is that simple – resolve to have a strategy to improve your PJDA through awareness of feelings and emotions with the goal being to be able to tell the difference when you are feeling one type versus the other. It works for everyone.

Last weekend, a group of the world’s preeminent neuroeconomists met in Evanston and the research findings reported on were strikingly different from even two years ago. Virtually nothing about system 1 (logic) and system 2 (emotion) and a new found appreciation for the integrated role of feelings and emotions in every risk decision. Antonio Damasio, one of the world’s most famous neuroscientists gave the keynote lecture Friday night with a title “The Primacy of Feelings”.

Here are a few more highlights – both from presentations and from up-and-coming research by doctoral and post-doc students.

1. Something called the “orbitofrontal cortex” (which has been implicated in good decision making) was recast as a kind of keeper of the facts that predict “value” – a sort of what-if modeler but not the decision point. (This theory works well, in our opinion, with the new information from R. Douglas Fields in The Other Brain that says neuronal networks aren’t where the real action is anyway).

2. A very helpful lecture by Reid Hastie of The Booth School of Business at The University of Chicago which categorized the working theories in Prospect theory, Behavioral Finance and decision-making as:

a) Query theory or something called cognitive microgenesis. He attributed this to Elke Weber and Eric Johnson at Columbia.

b) Emotional modulators which is a bit like our working theory of emotional context.

c) Peter Wakker – updated Prospect Theory

d) System 1 vs. System 2 – “not satisfying”, “little direct evidence which system controlling”. As I said above, this was literally the only mention I heard – a vast difference from 2008 and even 2009. In other words, emotion seems to be truly out of the dumpster even with this group which tends to be very cognitive oriented.

e) System 0 – Unconscious thought theory (one of our favorites) and the comment was [studies] “very repeatable”.

f) Ego Depletion – Willpower, like muscles, tires out. This relates to the reports of decision fatigue and the higher chances of being granted parole if an inmate has a morning appointment.

g) Reward meters – Paul Glimcher of NYU and subjective probabilities (another of our favorites). This is about information integration and is where the whole field is going. Soon I predict we won’t be talking about a neural circuit for this or that but a neural circuit as a part of a larger system that gives rise to perception and the judgment of value in any given decision.

…and that is just from the two introductory talks on the first morning of three days!

Other interesting studies -

1) “Rats increasingly relied on prior knowledge with increasing decision uncertainty” (Hirokawa, Cold Spring Harbor) – i.e. context is everything in uncertainty.

2) Need to factor in regret theory as “counter-factual” evaluations are part and parcel of thinking about prior decisions.

3) Large bonuses make monkeys crazy with anxiety and reduce performance!

The conference lasted three days so a full summary would be a very long post. Suffice it to say that the focus has turned to what we here at ReThink call social and emotional context. The brain and the mind are still a long way from being fully understood and anyone who tells you differently is over-reaching. Having said that, it is becoming clear that whichever structures are doing whatever task, they are working together to integrate a conscious and unconscious assessment of the facts, the contexts and the feelings associated with any perception and decision.

It’s easy to forget that markets are nothing more than a mechanism to transmit value and value is nothing more than perception. Hence markets are nothing more than perception. Likewise, it is easy to forget that in all of our fundamental, technical and economic analyses, we are trying to decipher and predict both current and future perception.

Perception is a human entity. It is context and belief driven and as such both ephemeral and illusive. It’s why looking at numbers feels so much safer.

But yet if the markets are perception only then what does that make the numbers? How about a language or a piece of art? In a language – take English – you have multiple versions, American, British and Asian at a minimum. The meaning of a sentence can only be known if you know which one you are speaking and in what context you are speaking it. Such is the same with say Dow 12000 now. It means something totally different that it did a month ago and something totally different if you are long or short biased.

The point really however is that all humans are good at predicting all other humans (males predicting females aside). We are naturally built to do it and if we consciously work at it, we will gain a much more robust context in which to make our market – or other uncertainty – decisions. Take today – anyone who does a little reading can make what I predict will turn out to be an excellent prediction on the behavior of the current key market influencers – the central bankers and country leaders of Europe.

Make yourself a social map of their motivations and ask yourself, what kind of events do you think will happen. Doing so will give you a better peek into the future – as long as you remember one thing, their timeframe might not be yours.

So Sunday night came and went without a market meltdown. And now the market talk is of “we all know they will make some kind of deal” so … what’s the big deal?

Let me ask you, what if they don’t? What if Congresspeople who truly don’t understand how financial markets function on perception decide that their own re-election trumps any reasonable compromise? What if President Obama comes to the same conclusion? Neither is that outrageous an outcome at this stage. And today’s run-of-the-mill sell-off only increases the likelihood that no deal – or a stupendously bad deal – will be made.

Why?

Ask the question in terms of the social-emotional context for the decision makers. What drives them – not from a logical or even ideological point of view but from the one that counts – the context of how they feel? Decision research proves you have to have a feeling to make a decision so in the end, what they do will be based on how they feel.

Sure they can talk about lofty goals but at the end of the day – particularly for the President – what happens now is about getting re-elected. And what happens on the side of his opponents is making sure he doesn’t – and they do. Both will be constantly calculating their predictions for this – as opposed to their true desire and obligation to vote in the best interests of the country. Obama has repeatedly shown that he has no core so he may blink but he now has the Senate substituting for him. (BTW – shouldn’t it have been the other way around – he stepped in, not out?)

Financial markets may be relatively sanguine now but that in an of itself should be a warning sign – they aren’t acting as expected. Whenever that happens – something else is afoot. Mapping the emotional trajectories of the decision makers provides a wide open window into the future.

The now vast field of behavioral finance can outline and articulate the mistakes we make in our choices. We look at questions that are in effect the same depending on how the question is worded, we evaluate the gain or loss of the same amount of money in a lopsided way, we can be primed to give one answer or another with every thing imaginable under the sun – including a simply hot or cold cup of coffee.

The typical answer is to think harder… to use our intellect to work harder at seeing and then behaving in a more theoretically and objectively rational way. But does it work? Furthermore, does the dilemma even fully describe the whole “problem”.

The solution to creating behaviors that we want is to put the right context back into our consciousness. Virtually every single one of the list of behavioral mistakes can be explained if one looks to see what emotional context was induced by what came just before. It really is that simple – what is the context of emotions the subject is experiencing? What context was induced either by the wording or the previous event or the manipulation of the subject’s feelings through experimentation with pictures or conversations or….

For a long time now, we have only looked at two dimensions of the psyche – thinking and behaving. We subjugated emotions to some deep dark and useless place. Ironically, they explain just about everything – if we will only elevate them to the same level of analysis as our thoughts, models, math and behavior…

A huge misconception exists across both the professional world of psychology as well then as the average human decision maker. It is axiomatic to believe in “controlling emotion”. Professional researchers talk in terms of “emotion regulation” but it is the same thing – and there is a very very good chance the entire concept is flawed.

First of all – an emotion alone never ever did anything – it didn’t make a bad decision, lose money or anything else. An emotion alone is just a feeling – with content and a source. It really is only a piece of data – a reflection of meaning. So why control something that alone is essentially powerless?

Well we talk about controlling emotions because in misunderstanding them for the better part of the past 70 years, we confused them with actions – the psychological and physical events that need controlled. It is only a movement – a physical action that can cause anything to happen. So in order to properly leverage the information, motivation and other valuables within your emotions – first remember that you only have to control the action you take. Make them two separate things – because they are.

Second, figure out that you can feel bad – angry, sad, agitated … whatever… and not do anything – except analyze what is REALLY making you feel that way. Until you KNOW what is really making you feel that way, keep analyzing the data because once you know you have created mental and psychological capital – which is power.

This is huge – you have the ability to create power within yourself simply by understanding yourself. You have the ability to create change simply by analyzing the emotion data and not by mixing it up with action.

A few bold neuroscientists talk about this – they buck the trend of the cognitive revolution and notice that we don’t just think and do, we feel, think and do…. and we need to consciously and explicitly leverage all three. There is even research that shows the attempt to control certain types of emotions makes them more intense – and more likely to be acted out – (which is what is happening – if you don’t understand the emotion, you automatically act it out).

If you want to ACT in the way that serves your goals, stop trying to control you emotions and use them purely as data. Choose your actions carefully once you understand your emotions.

It works.

In the US at least, it’s taken as a given that feeling good is better than feeling bad. We “look on the bright side” as a matter of social pressure. If you say you feel angry, sad or anything else “negative”, you get pushback and even disdain. But a recent paper shows that this is very cultural – and possibly destructive.

This adds to the work of Kateri McRae and colleagues now at Denver that showed when people tried to use “re-framing” in order to change how they felt about something with “bottoms-up emotion” (more meaningful), their anxiety went UP!

What is going on here? Many scientists will take it for granted that trying to maintain a positive attitude is “adaptive” – or helps you. Yet we have two research papers and hordes of anecdotal evidence (and lots of papers that I don’t know about), that show that listening to the message in a negative feeling can both alleviate the feeling and turn into positive action.

Let’s just take a “funk” – the feeling of not wanting to do anything …. it scares people because maybe you or they /won’t/ do anything. On the other hand, let’s suppose one analyzes what is causing the funk – and finds out it is…. xyz. Now if one is careful about this analysis, they can get to the place where “the funk” has taught them something about themselves or their situation that is useful.

Or just take fear, oftentimes we experience it in a twisted way but at its core, it is meant to protect us. We just haven’t learned to look at emotions as data – or the communication of data from the unconscious perceptual apparatus of the brain.

The brain relies on and communicates emotional information – negative and positive – if we reduce our fear of feeling bad, we actually get a more robust data set into our situations … and we in turn, can get motivated. If we squelch the feeling bad, the brain tends to act like a Yorkshire Terrier and just keep at it! … Net net – avoiding feeling bad usually makes it worse. Or as many clients have reminded me, “what you resist, persists“.