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).

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.

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!