The Trader's Brain
Why some traders let winnings ride when the rational person would cash out.
By R. Nelson Molina, MD. September 6, 2013
The answer may lie somewhere in the 96,000 kilometers (60,000 miles) of neural wiring inside our brains. For years, behavioral finance researchers have been aware that people's decision making is greatly affected by how choices are framed. A very interesting investigation from the Institute of Neurology at University College London finds that the framing effect on decision making is mediated by an emotional center within the brain: The amygdala.
The amygdala an almond-shaped part of the brain involved in emotion and decision-making; people with damage to the amygdala are more likely to take bigger risks with smaller potential gains. Whereas healthy control subjects who stood to win $20 but lose $15 were less likely to gamble than if they stood to win $50 but lose only $10, the patients with amygdala damage were much less affected by the disparity between potential gains and losses. In some cases, they chose to gamble even when the potential losses outweighed the potential gains.
The explanation. When blood flow is directed away from the brain's executive center, the frontal cortex, and the amygdala and associated emotional centers are activated. We are likely to underutilize those executive functions--reasoning, judgment, planning--and respond to our (emotional) framing of choices with a lack of effort. Going with our feelings might just be the reason we don't think through our choices.
Now emotions definitely count, the amygdala is also implicated in the detection of emotionally relevant information present in contextual and social emotional cues. A study conducted by Lo in 2005 confirms a clear link between emotional reactivity and trading performance as measured by normalized profits-and-losses (normalized by the standard deviation of daily profits-and-losses). Specifically, the survey data indicate that traders whose emotional reactions to monetary gains and losses were more intense on both the positive and negative side exhibited significantly worse trading performance, implying a negative correlation between successful trading behavior and emotional reactivity.
Traders can make mistakes, and the more we can understand about why and how, the sooner we can correct them. Most-successful traders are those who manage to keep their emotions on an even keel whether they were making money or losing money.
Conclusion: Researchers scarcely understand what goes on inside our heads with 150 billion cells, each with 2,000 to 30,000 synapses but We well know that successful traders understand risk, absorb information and make quick, calculated decisions. They have the self-confidence to take a loss and move on. In a very important sense, successful traders train their brains for accurate decision-making under stressful circumstances.
Confidence is your only defense against your brain switching to “survival mode,” a mental-emotional condition run by the amygdala in which you are at high risk of self-sabotaging behaviors.
Sources: Bloomberg Markets, Vol. 15, No. 3, February 01, 2006, pp. 34-45 Lo, A.; Repin, D. and Steenbarger, B. “Fear and Greed in Financial Markets: A Clinical Study of Day-Traders.” MIT Laboratory for Finan- cial Engineering Working Paper No. LFE– 1060–05, 2005. Loewenstein, G. “Emotions in Economic Theory and Economic Behavior.” American Eco- nomic Review, 2000 (Papers and Proceed- ings), 90(2), pp. 426–32. Sitkin, S. and Weingart, L. “Determinants of Risky Decision-Making Behavior: A Test of the Mediating Role of Risk Perceptions and Propensity.” Academy of Management Jour- nal, 1995, 38(6), pp. 1573–92. Gabaix X, Laibson D. In: The Psychology of Economic Decisions, Vol. 1: Rationality and Well-Being. Brocas I, Carrillo JD, editors. Oxford Univ. Press; Oxford: 2003. pp. 169–183.