A Study On Trading And Emotions by Brince Wilford, Covenant Capital Management
In 2005 researchers from Stanford, Carnegie Mellon and the Univ. of Iowa published a study focusing on the role that human emotion plays in investment decisions. (See “Investment Behavior and the Negative Side of Emotion” Shiv, Loewenstein, Bechara, and Damasio) The study investigated how normal participants, people with normal emotional brain functions (the “normal” group), differed from people with lessened emotional function. The “non-normal” group was comprised of subjects that had stable focal lesions in the emotional regions of the brain. That is to say, they had conditions in which the emotional areas of their brains were less responsive than those of the normal group. The cognitive intellectual abilities of both groups were equal.
The participants each were given $20 and a series of 20 investment decisions to make. From a logical standpoint, the better decision was always obvious. For example, a $1 coin flip wager would pay $2.50 when the subject guessed correctly, creating a clear and significant advantage to choosing to take the risk. In fact, if the subject invested at each opportunity for all 20 rounds there was only a 13% chance of ending with lower total earnings than if one chose to not participate at all and just kept the $20 that they were given to begin the experiment.
As hypothesized, the target group (emotionally impaired) earned much more money (average $25.70) in the experiment than did the emotionally normal group who averaged $20.07. The pattern of results also showed that the two groups had relatively equal results early in the experiment. However, the normal group grew more reluctant to invest as the experiment proceeded while the target group maintained a consistent appetite for risk. The reluctance found in the normal group also became more pronounced after the normal participants experienced a loss while the non-normal group continued wagering in a consistent manner, even after losses. The researchers concluded that one potential account for this tendency was that the emotional reactions to the individual outcomes on preceding rounds affected the logical decisions on subsequent rounds for the normal group, but not for the non-normal group. In other words, it demonstrated that the emotional impact of a losing round impeded the subjects’ ability to make a sound and rational decision in subsequent rounds. Additionally, the normal group’s reluctance to wager after losing rounds was not off-set equally by increased appetite for risk after winning rounds. (This finding comports with other studies done in the field of behavioral economics that suggest that the emotional ‘pain’ associated with financial loss is greater than the emotional ‘joy’ of an equal financial gain. That is to say that the pain of losing a $100 dollar bill, for example, is physiologically more impactful than the pleasure of finding a $100 lying in the street.)
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So, what does this mean? If, in fact, emotions impact one’s ability to choose wisely, how does one mitigate the effects of emotion so that one can continue to make decisions that are optimal? We (CCM) believe that the best remedy to emotional “self-sabotage” is to remove emotion as a component of the investment decision. A mechanical trading model can be very useful in this task as trading decisions can be pre-determined based on probability and statistical expectancy, rather than by being deliberated in the emotional wake of recent outcomes. We are also well aware that even the best mechanical protocols are useless if the trading manager lacks the discipline to comply them. As a famous football coach once stated, “Everyone has a game plan until they get punched in the mouth.” We address discipline in a number of systematic internal checks among our systems, employees, and principals. And having over a decade of experience in taking punches we humbly hope that we have demonstrated the ability to maintain the discipline that our endeavor requires.
PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS
About Covenant Capital Management
“Covenant Capital Management is a boutique CTA that has been managing client assets for over 15 years. CCM has offices in Nashville and Chicago, and employs a systematic trading methodology across global futures markets. The goal of Covenant Capital Management is to provide clients with the highest risk-adjusted returns available in the market. You can reach CCM at their website www.covenantcap.com or on twitter @covenantcap.”