This is a true story.
3 years ago today (I have this weird memory for dates), I spotted Jamie Dimon and Bill Daley sitting outside Gibsons in Chicago. I just happened to have come from a lunch with Patricia Crisafulli who had written the House of Dimon and I had her book with his picture on the cover in my purse. I crashed his table and he graciously opened a discussion about what I might have Tricia write for me as she is also a ghostwriter. I said “well net net, a new psychology of trading”. To which he said, “oh really, tell me more”.
In a lot fewer words, I said what I said over at AllAboutAlpha a few months ago. Until we wake up and get serious about the missing psychological dimension in risk management, these disastrous losses will keep on happening. It isn’t about the Fed, it can’t be handled by regulations and surprisingly it fundamentally (from the human mind’s POV) it isn’t even really about greed.
It IS about getting out of our misguided quant religion and accepting what we know about how our minds REALLY make judgment calls. From there we take on the task of systematically exposing/analyzing/accounting for all of the truly omnipotent subjective factors.
The complex math has its place. But it also tricks us. It is actually easier, makes us feel good and then wham, does us little good until it is too late to solve the problem. Once the math is telling us the positions are careening out of control, the rest of the world is trading against us. It happened at Bear Stearns and now it has happened to their adoptive parents (ironic huh?). It happened before that at LTCM.
This is the thing – really taking the neuroscience of decision-making, emotion and social thinking seriously is handing us a solution on a nicely arranged silver platter.
1. Realize that all markets, but particularly exotic ones, have a limited number of players and those players can all play against you. It is musical chairs and occasionally the music stops. You may have gotten a chair every single time in the last 100 games but there is always the next time – the time when you have indeed forgotten what it feels like to not get a chair.
2. Go back to Harry Markowitz and Asset Allocation 101. Knowing what you believe is step #1! Jamie said “we believed …” on the conference call last night but how much analysis of those beliefs did they really do?
3. Analyze one powerful emotion – for its presence and degree. Don’t deny it is there. Psychological research says it is – frankly, particularly in competitive males. Academically, it is fear of future regret and in practicality it is fear of missing out.
In both 2 and 3, you can start with a very simple scale, that everyone making new risk decisions has to answer to every time. 1-5. 1 = “I don’t believe it at all” or “I have NO “FOMO”.
5 = “I believe it like I believe the sun rises in the east” or “I am so sure this trade is going to work that I can’t not make it.” Forget my friend Jamie, how would Corzine have answered? How would it have worked if his board instigated and completed a thorough discussion of these psychological questions?
The odds of the “egregious, stupid” mistakes would go down. Plain and simple.
(Oh just for the record, Tricia is great but I did write MARKET MIND GAMES all by myself and I did send Mr. Dimon a copy back in January ;).