Edited by Simon Kerr, Principal of Enhance Consulting
The Brain’s Rapid Responses – Dopamine and the Amygdala
The brain has three basic responses in forming expectations of future outcomes. They all involve the dopamine system—a set of neural circuits. When these neurons become aware of something important nearby, they set off a series of rapid signals. When it’s something potentially rewarding, there’s a ten-fold increase in signals. When encountering an unexpected reward or a larger than expected award, the firing rate jumps almost instantaneously.
Once we experience a handful of similar experiences, we begin to respond to the anticipation of a reward. The ability to identify a predictive cue is in itself rewarding. Think about Pavlov’s famous experiment with dogs. Ultimately, the dogs salivated not when they got fed but when they heard the bell signaling that they were about to be fed.
Investing works in the same way. We have the formation of analysts’ consensus for earnings. The stock will not rise when it beats the consensus; it rises on the realization of a consensus. The prediction gets the dopamine churning. It’s also similar to identifying a hedge fund manager who can reliably produce alpha. We might get excited that one or two signals are in place before we actually identified the manager. You may already be on the hook before you’ve done half your due diligence. The final element occurs when the expected reward fails to materialize. Your dopamine system basically shuts down. Your brain falls into a motivational vacuum filled with stress. That brings us to fear.
Amygdala is one of the main brain structures involved in bringing about fear. And it’s a rapid response system. Modern portfolio theory is that people are rational agents, able to make a judged and disciplined mental tradeoff between risk and reward. In times of real market terror, fear prevents a cost/benefit analysis. We can only think about the costs. When confronted with a fearful stimulus, the amygdala fires 25 times faster than you can blink your eye. The time to rehearse the worst-case scenarios is not when things go bad but when things are going well. Deep into a bull trend a lot of people find themselves trapped in a situation of seeing only blue skies ahead.
Working Under Stress
The trading world is inherently stressful, and is particularly so in market crises. When a trader is under stress or fearful of what’s going to happen, things go awry. He may hold onto positions hoping they’ll turn around. Or, being so uncomfortable, he gets out just when they begin to work.
People take on more risk in riskier situations because of the brain’s hard-wiring. Experienced traders detach themselves from emotional responses. They’ve learned how to do it either through yoga or meditation. It brings them to a more tranquil state. They see the distinctions. They don’t react emotionally, and they don’t misinterpret events.
Here is an example of a hedge fund manager seen by a trader trainer recently. He had lost almost everything. He was focused on what went wrong, and he was berating himself. When he talked to his investors, it was a hand-wringing confessional. He didn’t look at what went wrong or how he failed. He didn’t see it as a positive learning experience.
It turns out that he didn’t want to manage – he wanted to trade. But his firm grew and he added to his staff. Many of those that came in were not equipped to do the job, and didn’t complement his skills. He was unable to make forceful decisions or deal with people proactively. He understood the game but not the organizational issues now required. The hedge fund world is filled with people skilled at choosing stocks. But they’re not necessarily skilled at managing.
You have to consider this when investing with a manager. Does he understand risk? Is he looking for just a winning percentage? Or is he looking for a slugging ratio where average wins are 1.5 greater than average losses? The least successful people stayed wedded to their ideas and not to market forces. The better way is to pare down; stay in high-conviction ideas, wait, develop patience until the market turned around.
If a trader has a goal, you have to have a plan. You need to work on that plan. To deal with stress, you need a plan. The pilot who ditched the plane in the Hudson trained all his life for that moment. When it came, he had three seconds to make a decision that saved all aboard. Training beforehand helps you focus in stressful situations. In stressful times, you don’t have time to start training.
This article is based on talks given post Credit Crisis by Jason Zweig of The Wall Street Journal and Dr. Ari Kiev of Kiev Consulting.
Related articles: Are Hedge Fund Managers with More Than Two Screens More Productive?
Consulting One – Team Working in Hedge Funds
Five Things The Seahawks Super Bowl Win Could Teach A Hedge Fund Manager
Intuition and Impulse in a Great Trader
About Enhance Consulting