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″

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.

Oh how soon we forget…

The specially appointed Financial Crisis Inquiry Commission released their report yesterday and despite the importance of unraveling what really went wrong, the WSJ covers it only on page 4! Now of course, the economy is picking up steam and the stock markets are back above the levels of late 2008 … so maybe we can just forget the whole thing ever happened and…. but of course, almost all of us know where that leads… particularly in the era of QE2.

Phil Angelides, the chairman, says “The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire“.  Well yes of course, human decisions by definition must be at the heart of the matter. The question remaining however is what can be done to educate and induce better decisions – particularly in risk management – in the future.

Lots of talk right now focuses on behavioral economics – or the research that really tracks our choices. The idea that we make “rational” decisions obviously isn’t the real model of the human. What lacks however in the whole field of behavioral finance is the “why”. Generally the answer given is that we didn’t think hard enough but that just can’t be true. We thought as hard as we are capable – at least under the current model.

We are taught from early on to use logic, reason and by extension – math. But numbers look you in the eye and lie.

This strategy also doesn’t take into account what is becoming more clear every day – we make all of our decisions within a context of feelings. I call it the all-important “fC”. Those feelings – or these “fCees” (what is going to be the plural of that anyway?) – include our pre-existing beliefs, our confidence, our assumptions and our fears. Certain fears for example have been proven to be more motivating – the fear of missing out for one.

Understanding the financial crisis requires rethinking thinking itself. It requires understanding what an over-arching role feelings and emotions play in decisions about uncertainties in the future. This is what we are finding the brain does. It isn’t an argument I am making. It is how our brains fill in the blanks when not all the information we need is known. It is what our brain does when we are contemplating how things will play out in the future.

We need a revolution in our own conscious minds that makes us see ourselves as we are once and for all. We need to admit that how we feel makes all the difference in the world to what we do or decide.

This is the qualitative side of risk management. It is the missing piece that if employed by enough people, would prevent another crisis.

At the recent Neuroleadership summit in Boston, Lisa Feldman Barrett articulated a whole new view on the appropriate model for understanding our thinking and our feelings.

“Lisa challenged some of the most deeply held ideas about how the mind works in her session. She stated that Daniel Goldman’s theory on emotional intelligence is largely incorrect. Studies show there are no specific anatomical brain regions pinpointed for any of the emotions. The brain is a more integrated system than previously imagined, with thinking, emotions, mind and body all contributing to our experience in a holistic way.

We here at ReThink couldn’t be more pleased! This holistic view of “thinking” is what we are talking about with our tag-line of ReThink Thinking. We are glad to not be the only ones out there advocating for a total change in viewpoint!

The idea that emotions are old and separate and to be overcome just doesn’t cut it anymore. Logically it doesn’t make any sense anyway as to make any sort of decision, provide any sort of leadership or set out on any sort of adventure towards a goal you need some motivation and some confidence. Both are feelings! Motivation is wanting something and confidence is a feeling that you can get it or the decision will be right if you take it.

The new challenge then becomes how do you learn to work with the ephemeral and illusive qualities of feelings and emotions? How do you treat the physical, visceral experiences of feelings and emotions as data?

1. Truly change your mind about the conventional wisdom and decide that you will begin working with your brain/mind/psyche in this body/brain/mind way – no more dualism and no more tri-une model of the brain!

2. Begin tracking your feelings – feelings of all types: physical, emotional, intuitive.

3. Put yourself in situations where you can “hear” what you feel and continue the tracking (noting your observations).

4. Categorize these experiences. Name them (for yourself).

5. Resolve to always know the “fC” or context of feelings you bring to a perception, an analysis or a decision.

6. Use the knowledge of your “fC” to further inform yourself about your biases, expectations, nuances of knowledge and true reasons for believing in one option versus another.

This is a whole new strategy for many people. It is a systematic way to work with what seems VERY un-systematic. The irony is once you get solidly on the path you find that there are actually a relatively small number of feelings you experience and you can begin to use their categories to help you make better decisions and seize better opportunities. Most people also find that their personal relationships improve. (Honestly if I have gotten one comment to the effect of “My wife and family say I am so much easier to get along with… I have gotten a few dozen!)

This isn’t emotional intelligence, it is actually self and social-intelligence…  kinds of knowledge that can be leveraged in essentially an infinite number of ways!

For the past 50-60 years it has been popular to relegate the very relevant and powerful dimension of emotions to the category of “to be controlled”. On one hand, we talk all the time about how confidence, which is a a feeling more than anything, is so important in all domains: markets, politicians, sports…. and yet we fail to actually systematically and directly work with it or any of the other feelings that get in the way of performance.

What you say? We fail to systematically work with? Really? Aren’t there an endless number of coaches and methods for dealing with the vagaries of the illusive, ephemeral whims of confidence, fear and all of their cousins?

Well yes there are many people trying but I am really talking about an underlying coherent theory of what the subject matter is about and then the follow on logical approach to dealing with it. THAT we don’t yet fully have.

But we are close. The Boston ladies (forgive me in advance) Jennifer Lerner of Harvard’s Lab on Judgment and Decision Making and Lisa Feldman Barrett head of the Interdisciplinary Lab on Affective Neuroscience down the highway at Northeastern are both putting forward new conceptions around what we have relegated to “animal spirits”. Like me, these women don’t appear to be content to allow what on some levels we all realize is /the/ most important factor in all of our endeavors- the underlying context of feelings (or the “fC” as I like to cal it) – to continue going on being swept under the intellectual rug.

I encourage you to read both. We are going beyond animal spirits and we are moving quickly!

Here are a few links.

The Science of Emotion by Barrett.

A number of papers – but the “Government Executive” is a perfectly good place to start.

More importantly, I encourage to rethink feelings and emotions. Think of them first as data… then as something to be analyzed and understood and only third as something to fuel your actions – particularly when they are hiding outside of your awareness.

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).