Denise Shull, founder of the risk and performance advisory consulting firm ReThink Group, argues that traders and investors will improve their bottom lines if they better understand their emotions. Numbers, she writes, “look you in the eye and lie.” Both rationalism and empiricism come up short. The key to market success lies in leveraging emotional introspection and analysis into informed trading behavior—first and foremost, risk management.

In Market Mind Games: A Radical Psychology of Investing, Trading, and Risk (McGraw-Hill, 2012) Shull argues that we would “be able to extract a powerful advantage if we spent more time logically analyzing what the numbers cannot tell us.” (p. 20) Quantitative analyses are merely clues, not answers to what all traders are trying to figure out—other players’ future perceptions.

As it turns out, we all can predict (some admittedly better than others—perhaps an explanation for those seemingly natural born traders) what other people are going to do. This “pattern recognition of likely human behavior” is called “theory of mind,” or ToM. It is “the key to accurately reading markets.” (p. 63)

Looked at from another perspective, trading is a case study in dealing with uncertain scenarios (as opposed to risky situations). A 2005 study found that the brain handles risk and uncertainty differently; confronted with risk, blood takes a different route through the brain than it does when dealing with uncertainty. The researcher “proffered the idea of an ‘uncertainty circuit’ or the idea that a sort of red flag went up saying ‘more information needed.’”

Shull argues that this research undercuts “maybe the second most repeated rule of trading—‘plan the trade and trade the plan.’ … This supposed truism assumes a computer model of thinking. In practicality, it leaves very little room for context and certainly none for a warning flag that more information must be obtained. Traders try to do exactly what they planned while their brain fights them to find more information or to scramble in the face of a clear, but maybe only subconsciously perceived, threat.” (p. 77) That is, although it is important to start with the right type of game plan, “good judgment on the fly will be ultimately what wins the game (remember your brain when faced with uncertainty will make judgment calls whether you ask it to or not.)” (p. 117)

To be a successful trader it is not enough to read the markets. Traders must also read themselves to figure out (not control) what feelings, physical and emotional, are fueling their judgment calls.

Feelings should be viewed as data to be captured and then analyzed. “Just like if you had any new data set to work with, first you would try to get the scope of it, look at it from different angles to get a sense of what you were dealing with, and then go about ways to monitor, track, and categorize.” (p. 125) Knowing yourself and knowing how you feel (your emotional contexts) at any given time will give you a risk management edge. It will help you avoid those “What was I thinking?” moments.

Shull spends several chapters describing some of the most common emotions traders bring to their decisions. For instance, she asks the reader to determine where he is on the spectrum between the fear of losing money and the fear of missing out. (more…)