As I prepare for The Galtere Institute’s Behavioral Finance symposium, I am doing what I always do before I speak – catching up on the latest studies on emotion and risk decision making. For example, did you know that there is actually still much disagreement in science about what emotion is and how it works? There is the old (as in 1800’s) William James’ idea of basically we behave and then we feel. There is the five basic emotions idea and now the relative new kids on the block (spawned from 21st century neuroscience) are the appraisal and the constructivist theories.
The data from traders most closely matches the appraisal theory and it’s associated Component Process Model. Emotions add information to any situation. Handled as they appear to be designed, they inform us on how to make our best choices. The experience of having a feeling provides “a latency” (Brosch et. al., 2013) between a physiological reaction and an actual tactical move on our parts.
The problem for traders lies in the fact that for all practical purposes, everyone has been educated to follow earlier and incorrect ideas. The attempt to take emotion out of risk decisions diverts their energy directly into action instead of stopping at the analytical step noted above.
To make this point practical, let’s think about the common experience of making a trading decision that in retrospect is regrettable. Traders often ask “What was I thinking”? A common answer, when that question is analyzed, is that the psychological experience in the moment was wanting to be right or prove how smart the trade really is/was. Typically the trader didn’t realize they felt this way until after the fact.
What happens is the potential money made or lost is discounted when compared to the immediate ego-reward of feeling smart. (In neuroscience, this is called inter-temporal discounting – a smaller reward now is overvalued versus a bigger reward in the future). One solution to this is indeed appraising the situation and analyzing the emotions. Ask would I rather feel smart now or get paid more later?
A second related solution is to project how you will feel in the future if … . In other words, if I put this trade on (or don’t get out now), how will I feel tomorrow? This uses awareness of likely future emotions as a weapon against acting out the unconscious emotion of wanting to be smart in the moment.
Notably, it’s also leveraging a completely different view of how emotion can inform us.