What Were They Thinking? From MF Global to Raj & Bernie to LTCM…

As investigators continue their search through the ashes of yet another billion-dollar bonfire and as the CFTC calls for still another regulatory revamp, we find ourselves asking the virtually perennial question: “What were they thinking?”

Given that about the best we ever come up with is “greed,” could it be that as the parades of trades gone wrong marches on, it’s time to ask a different question, or maybe two questions.

For one, did you know that it is literally impossible to make a decision without emotion? I bet you didn’t. In fact, I bet your first response to such this assertion is to start listing all of the kinds of decisions that seemingly get made without emotion. But alas, a trained eye will easily spot the most easily disregarded emotion in finance – confidence.

Back in 1952, Nobel Laureate Harry Markowitz laid out stage one of asset allocating as the process of deciding what you believe. To believe is to have confidence and hence, we like our fund managers to note their conviction levels. Confidence also allows us to choose the appropriate implied volatility number for a new model and to make any other of the myriad of everyday judgment calls required in our money-running land.

Invert the indisputability of required emotion and what you have is an emotional context for every single decision that gets made. In other words, the right question is not what were they thinking, but what were they feeling? Get organized about detailing what feelings are being acted out and you’ve landed on the missing link in risk prediction. Not only have we made the logical error of attempting to control emotions when it is actions that count, we have inadvertently denied ourselves access to the most predictive data of all.

Escaping not only the next bonfire but also what amounts to The Matrix of purely mathematical risk management demands a next-generation effort to develop the correct qualitative frameworks of emotion analytics. Emotion Analytics you say? How is that even possible? Isn’t the true frontier of the human mind still light-years away?

Actually it won’t be as nebulous as it might sound. For one, at their core, all feelings may boil down to an evolutionarily adaptive dichotomy of “approach” or “avoidance” or “want more/want less.” Even more importantly, however, it’s been shown that by adding something called regret theory to the traditional model of rational decision making gives you a framework for something that looks much more like how people really do make decisions.

In laymen’s terms regret theory amounts to the fear of missing out. And if you think about it, the fear of missing out – or rather the acting out of an unrecognized fear of missing out – explains getting into excessively risky trades to begin with and even more importantly to the failure to exit trades gone wrong when there is still time to survive.

So are we comfortable relying on regulation and prosecution or will we take on our own aversion to ambiguity and deal in the arena where decisions truly emerge from? If it’s the latter, make the question of  “Where are we on the spectrum between fear of losing money and fear of missing out?” not only an institutionally acceptable question but a required review in any risk decision. Routinely researching internal and external emotional contexts offers a new and needed kind of telescope into the processes that pre-stage disaster.

Imagine if the geniuses at LTCM or the board at MF Global had executed a psychological risk review? What if we all realized that Mandelbrot’s fractals apply not only to market data but to our own need to be smarter than the next guy – or least to be right? Fear of losing can really be fear of being wrong and fear of missing out can really be fear of falling behind and each of us comes to work with some quotient of that in our unconscious emotional context. In other words, Jon Corzine and those before him should have had to provide a robust answer to how their risk decisions were not the embodiment of these fears. It may be the human condition but we can still take on the challenge of creating the tools to evaluate the right mix of qualitative and quantitative analyses.

Instead of attributing good trading to the right mix of genes and testosterone and bad trading to, as the English used to say “low moral fiber,” let’s take what the labs know about emotions, memory, meaning and decision making and get to work on how to identify the emotional and social contexts that drive our perceptions and judgment calls. If the top neuroscientists in the world are telling Charlie Rose that “we need a whole new model of the brain” is it really such a stretch to admit that we also need a whole new paradigm for risk prediction? It’s that or resign ourselves to regulation, prosecution and knowing not only in our hearts but as a matter of experience, that numbers alone can and do look us in the eye and lie.

Denise Shull, Author Market Mind Games – a Radical Psychology of Investing, Trading and Risk & Founder of the Wall St. Risk and Performance Consultancy, The ReThink Group, Inc.

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One Comment

  1. Gocadog
    February 14, 2012 at 11:05 pm

    As fate would have it, I recently posted a short research note on the role of confidence in financial market bubbles and crashes: ” A Note On Confidence Momentum And Term Structure of Confidence with Applications to Financial Markets”. That note is available at http://ssrn.com/abstract=2003319 It shows how and why subjects transform gain domain to fear of loss, and transform loss domain into hope of gain. So that over confidence (hope) and under confidence (fear) are driving forces behind perceptions of risk.

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