The full title of this book is Investing and the Irrational Mind: Rethink Risk, Outwit Optimism, and Seize Opportunities Others Miss by Robert Koppel (2011).
Robert Koppel was a floor trader, a hedge fund partner, and a president in Rand Financial. He also wrote another book, The Intuitive Trader: Developing Your Inner Trading Wisdom.
The book covers quite a broad range of topics, including:
- Different parts of the brain associated with different emotions
- The failure of relying purely on mathematical models
- Psychological barriers to investing (e.g. not defining a loss, getting locked into a belief, revenge investing, etc.)
- Cognitive biases (e.g. confirmation bias, herd behavior, loss aversion, anchoring, etc.)
- Fallacies (e.g. gambler’s fallacy, hindsight bias, identifying patterns in randomness where none exist, etc.)
- Illusions (e.g. black-and-white thinking, overgeneralization, illusory correlation, etc.)
- How to deal with losses
- Have a well-defined risk management plan
- How to use intuition
- Need for psychological resilience and positive psychology
A good amount of research has gone into writing this book, as can be seen by the large number of endnotes, with quotes, research findings, interviews, other book sources, etc. sprinkled throughout the book.
The part that I liked the most was on the natural function of emotions / intuition as the mind’s method of quickly evaluating a situation. The research presented is consistent with Victor Sperandeo’s writings in his Trader Vic — Methods of a Wall Street Master book where he devoted a significant chunk of the book on trading psychology. To make sure the emotions (i.e. the assessments) are accurate, Sperandeo highlighted to need to critically examine the beliefs and values underlying those assessments and correct them if they are wrong, so that the emotions generated would be ‘correct’.
The other facet of the same ‘model’ is on how experts essentially train their subconscious minds (through conscious thoughts when they were novices) so that the subconscious mind eventually is the one that is chiefly responsible for the execution. The subconscious mind conveys its assessment through emotions / intuition / feel, which gets translated into actual action. That is the brain’s natural mechanism for learning something and becoming good at it, and trading is no different.
There is a related article here (link) that highlights the difference between what goes on inside the brain of an expert trader versus a novice trader.
Structure of the Brain
- Prefrontal cortex — Complex logical reasoning, planning, and decision-making.
- Parietal lobes — Integrate sensory information
- Temporal lobes — Handle senses of smell and sound, and responsible for processing complex stimuli such as faces and scenes.
- Basal ganglia — Responsible for body’s idling speed. When they are overactive, anxiety and feelings of panic result. When underactive, individuals wrestle with concentration and fine motor control.
- Limbic system — Center of the brain (the “old brain”)
- Hippocampus — consolidates information from short-term memory to long-term memory
- Amygdala — loss aversion, fear center
- Striatum — A major input station for the basal ganglia. Activated by stimuli associated with reward by way of dopamine receptors.
- Cingulate — Gear shifter which allows for the transition of attention from thought to thought and between behaviors. When overactive, people get stuck in certain loops of thoughts or behaviors.
Use Your Mistakes to Keep Learning About Yourself and the Markets
- In an interview with Tom Shanks of Hawksbill Capital Management, what came across to me from this thoughtful system trader was that he learned how to invest successfully by taking away lessons about the market and himself from each mistake that he made.
- He said, “Patience and diligence are rewarded. Profits will eventually accrue if you do the right thing and stick with it. That’s the most important thing.”
Emotions are a Kind of Evaluative Thought
- Psychologist Albert Ellis notes that “Much of what we call emotion is nothing more nor less than a certain kind — a biased, prejudiced, or strongly evaluative kind — of thought….. What we call feelings almost always have a pronounced evaluating or appraisal element.”
Emotions Is a Natural Mechanism To Help with Decision Making
- Our brain, drawing on emotional memory, has the capability to determine when our decisions are good or bad long before we consciously aware that we have decided anything.
- Real-life decisions require assessment through cognitive and emotional processes in environments that produce many complex and conflicting alternatives with a high degree of uncertainty. In such situations, cognitive processes often become overloaded, and we are unable to provide an analytically informed option. Somatic markets (physiological signals / states) aid the decision process.
- In cases where complex and uncertain decisions need to be made, the somatic markers from all previous reward- and punishment-associated experiences with the relevant stimuli (trigger) are summed to produce a net (resultant) somatic state. This overall state is used to direct (or bias) the selection of the appropriate action.
- This process may occur covertly (unconsciously), via the brainstem and ventral striatum, or overtly (consciously), engaging higher cortical cognitive processing. Somatic markets are proposed to direct attention away from the most disadvantageous options, simplifying the decision process.
- Antonio Damasio’s research establishes a firm biological basis for the critical importance of gut feelings.
Intuition Needs to Be Trained, then Supported by Analysis
- Denise Shull: Intuition needs to be worked on like a sport, gaining muscle memory for the experience of unconscious pattern recognition.
- Analysis needs to be used to support intuition, as opposed to the other way around. The point is to allow intuition to drive our analysis or our investment plan so that it guides our comprehension of circumstances. Used in this way, intuition allows us to identify opportunities and helps us decide how to react.
- Our trading plan verifies our intuition to make sure that we are not going astray.
- Seasoned traders at the trading floor feel the bottom intuitively long before they have time to analyze it as a buying opportunity. A 30-year veteran noted that he would always feel fast markets coming to an end “as if a wooden spoon was being shoved up my ass,” which forced him to buy the bottom.
Emotions and Thinking Have a Closed Circuit
- Both feelings and behaviors have a significant impact on thinking in the same way that thinking has an influence on emotions and behaviors.
- Evaluating is a fundamental characteristic of human organisms and seems to work in a kind of closed circuit with a feedback mechanism: Because perception (thinking) biases response (feelings) and then response (feelings) tends to bias subsequent perception (thinking). Also prior perceptions appear to bias subsequent perceptions, and prior responses appear to bias subsequent responses.
- The closed psychological circuitry of a faulty feedback mechanism reinforces biases, fallacies, and illusions.
- The solution to break free from the closed circuit begins with awareness, leading to cognitive and emotional strategies that re-interpret our market experience through language, belief, feelings, meaning, and action.
Awareness Leads to Rationality
- Denise Shull works with traders to become fully conscious of biases and tendencies. As traders become more able to see their tendencies through their conscious and unconscious, social and emotional lenses, they automatically become more rational.
Emotions Trump Rational Self-Interest
- Princeton professor Jonathan Cohen conducted a series of ‘ultimatum game’ experiments. A researcher offers a player a sum of money to divide in any way he chooses with a second player, who has the sole right to approve or disapprove the offer. If the second player approves the offer, the money is divided accordingly, but if the division is refused, neither player receives anything.
- When a player received a stingy offer, she exhibited intense activity in the dorsolateral prefrontal cortex, an area associated with reasoning, and in the bilateral anterior insula, part of the limbic region that is active when people are angry or in distress. Two regions of the brain were competing against each other to decide what to do: the prefrontal cortex wanted to accept the offer, and the insula wanted to reject it. Researchers observed that the more intense the activity in the limbic area, the more likely the player was to reject the offer.
- Not only are stingy offers refused when they are perceived to be unfair, but when emotional stimuli are present (e.g. being shown an angry clip beforehand), players reject offers that would otherwise be accepted. They consistently found that emotion trumped self-interest.
Ambiguity Creates Fear
- With greater ambiguity, people exhibit substantially more activity in the amygdala and in the orbitofrontal cortex. When it can’t figure out what is happening, the amygdala transmits fear to the orbitofrontal cortex.
- The amygdala is the structure in our brain that is responsible for our loss-aversion. The amygdala is critical for triggering a sense of caution toward making gambles in which you might lose.
- The level of ambiguity in choices correlate positively with activation in the amygdala and orbitofrontal cortex (i.e. increase loss aversion), and negatively with activity in the striatal system; and striatal activity correlate positively with expected reward.
- Our brains view the market as an issue of life-or-death survival rather than one of arithmetic problem solving. Under uncertainty, the brain is alerted to the fact that information is missing, that choices based on the information available therefore carry more unknown and potentially dangerous consequences, and that cognitive and behavioral resources must be mobilized in order to seek out additional information from the environment.
Vivid Events Distort Statistics
- Vivid events make a very strong impression on the mind, which causes the investor to internalize them in such a way that the likelihood of such events outweight statistical evidence (e.g. tech drops are volatile).
Experts Perform Using Their Subconscious
- While close attention is helpful when our task is novel or complex, it is positively destructive when our task is simple and well-practiced.
- Daniel Gilbert reported that when golfers were asked either to take their time and think about their stroke or to step up and swing as quickly as possible, novice golfers did better when they took their time, expert golfers did worse.
- Once our brains learn to do something automatically, they don’t appreciate interference.
Use Your Emotions to Your Benefit
- Andrew Lo (MIT) and Dmitry Repin (Boston University) did a study which found that traders who get caught up in their emotions tend to fare poorly in the market, but traders who rely solely on logic do not fare well either. The most consistently profitable investors use their emotions to their benefit without letting their feelings overwhelm them.
- Professional athletes have the same reaction — they use emotion to psyche themselves up, but they don’t let those emotions take them over.
Theory of Mind (ToM) Are Better Predictors of Success in Forecasting Stock Markets
- Antoine Bruguier did a study where they posited that humans understand stock markets by using Theory of Mind (ToM), the ability to attribute to others mental states different from one’s own (i.e. the ability to figure out what others are thinking or feeling).
- Behavioral tests show that ToM, rather than mathematical, abilities are better predictors of success in forecasting stock markets.
- Trading is essentially a social activity.
Have the Discipline to Keep Doing the Right Things
- Trading is just another competition. Winning is contagious, and the repetitive discipline to keep doing the right things begets more winning over time.
- Yra Harris: A serious setback has never bothered me as long as I stayed disciplined to my initial risk levels and did not pull my stops. I had a British pound / deutsche mark trade that blew up on me, but because I was true to my stops (i.e. did not pull them), it was the best loss I ever took. Had I hesitated, it might have been a major blow to my capital base and caused me to rethink my life in this business.
Having Confidence in the Face of Feat is Key to Market Success
- A seasoned pro noted that his fortune had been built on three things: knowledge, nerve, and the ability to lose money. Everybody has the ability to lose money, but it takes nerve to lose and then choose to stay in the game.
- Market success required ‘audacity’, to assume that you were smart and quick enough to make a trade and take advantage of opportunities once you were in a rut. Having a great deal of confidence in the face of defeat, even after taking a beating in the market, was key.
- Jack Schwager stated that because exceptional traders are confident that they will win over the long run, individual losing trades no longer seem horrible; they simply appear inevitable — which is what they are.