The Many Faces Of Risk – Faust

The Many Faces Of Risk – Faust

“It’s almost a badge of honor for investors to claim they’re emotionless about their investments. But if lacking emotions about your strategy or holdings increases the odds you’ll walk away from them when they become difficult, what looks like rational thinking becomes a liability.” — Morgan Housel

We all have emotions. From early perception to complex reasoning, emotion and cognition are inextricably linked. As the quote above eludes to, we can either deny this fact at the expense of an error — sometimes fatal — or we can play an active role in trying to understand how our emotional framework affects our trading decisions. Depending on your strategy, different temperaments can be more conducive to specific trading styles, timeframes, etc. How does volatility affect your emotions? Do repeated losses or gains change the level of risk you take or affect your ability to think clearly? Below I will introduce several concepts pertaining to emotion and decision-making, and how they can positively or negatively affect the amount of risk one takes. I will then share several tests that may be beneficial in helping to understand where you fall on the spectrum of each of these criteria. The goal of these tests is to try to better understand your emotional framework and how it may conflict or support your trading style. Ultimately, the objective is to evaluate if a conflict exists with your current trading style and modify your style to complement your emotional responses. The reduction in stress alone, on top of potential PnL improvement that this can provide, is worth it. As I’ve delved deeper into the research on emotions and financial risk I’ve come to the conclusion that some people should trade due to their innate temperament because it is conducive to trading, some people could trade with improvement and better understanding of their emotional pitfalls, and some people would be best off if they avoided trading due to strong divergences between their maladaptive temperament and the danger of compounding losses when trading as a consequence of their behavior.

Do You Wear A Seatbelt?

The topics presented below evaluate risk not just from a financial standpoint, but in the broader context of decisions through a variety of categories. As you think about the concepts and evaluate yourself with the tasks below, they may reveal connections between certain trading behaviors and risks you take in other areas of your life. What other aspects of your life come to mind as you are reading through the concepts? I have personally found that sometimes correcting a similar behavior in an unrelated area of my life can carry over into a trading habit that was based on the same underlying issue.

I Just Want To Get High

There are two behavioral systems that have been studied together in the context of financial decision-making. The first is the behavioral approach system (BAS) which is associated with sensitivity to signals of reward, non-punishment, and escape from punishment. It is believed to be the physiological mechanism that controls the motivational drive that humans possess. Stimulation of this system causes the individual to begin or increase movement toward goals. It has also been postulated that this system is responsible for the experience of positive feelings such as hope, elation, and happiness in response to these signals. Having a strong or chronically active BAS tends to result in extraversion.

Specifically, the BAS stimulates activities in response to reward signals (i.e., anticipation of a monetary reward) which is the main interest of this system in the context of trading. High BAS sensitivity appears to be linked to traits such as impulsivity, novelty seeking, and states such as positive affect and energetic arousal. When faced with the prospect of obtaining a desired outcome, high BAS individuals will fight more intensely in order to get it.

Focusing on reward sensitivity, this concept takes into account individual differences in the tendency to detect, pursue, learn from, and derive pleasure from positive stimuli. It is a component of temperament and personality that shows large variations between individuals and moderate consistency within individuals over time. More broadly it has been observed that investors who experienced more intense emotional reactions to gain and loss were poorer performers than those with more diminished emotional responses. Those with lower reward sensitivity performed significantly better when it came to measuring optimal choice behavior and, interestingly, this effect was not explained by differences in risk-taking behavior. Previous research also indicates that after periods of increased or decreased market returns, those with high reward sensitivity prefer riskier portfolios and trade more often, but these behaviors do not increase profits. This tendency towards higher risk underlines the more general observation that individuals with greater reward sensitivity are more influenced by the valence of risky-choice outcomes, resulting in overly optimistic beliefs about investments that lead to gains and overly pessimistic beliefs about investments that lead to losses.

Going back to the title of this section, what is your emotional response when taking a trade and when winning or losing the trade? Is trading an emotional roller coaster for you? Your answers to these questions can help inform how high your reward sensitivity is and the effects that it is having on your trading. More importantly, I have found it very useful to look at whether positive or negative circumstances are worth paying more attention to. A counterintuitive observation that I have seen when analyzing a string of bad trades is that the impetus for such cascading behavior could actually be a winning streak. Being higher on the reward sensitivity spectrum, I’ve added risk after wins in ways that I may not have normally done had the streak not preceded it. The subsequent loss then caused me to go on tilt and potentially misjudge the next opportunity due to being overly pessimistic from the loss. It’s easy to go back and look at where a string of losses started but sometimes it is important to go back further to see more subtle deviations, such as when you started taking increased risk or used different risk parameters while your performance was on a positive streak.

Though the research is not conclusive, there may also be a genetic component to one’s reward sensitivity. Since dopamine is related to risk-taking behavior, a natural first place to look would be the dopamine receptors. The current literature suggests that the most likely candidate correlated with risk-taking propensity is the dopamine receptor D4 gene (DRD4). Specifically, there is a variant, DRD4–7R, which is estimated to occur in 20% of the population. Studies have found that those with the 7R allele are less sensitive to dopamine which consequently means that they require a higher level of stimuli to produce a similar response in comparison to individuals who do not have the 7R variant. Many studies have been conducted to try to understand the link between this variant and specific risky behaviors, and have found a connection between individuals with the 7R allele and alcoholism, impulsivity, pathological gambling, and novelty-seeking. Nevertheless, the findings are divided when it comes to financial risk. This could be due to the inherent problem when dealing with simulated financial risk versus real life financial risk amongst other unknown factors. Losing five fake dollars doesn’t compare to losing 10% of your net worth. Perhaps a more individualized explanation for those possessing this gene variant will be discovered in the future.

It feels like modern society makes it harder to manage reward sensitivity due to the increased dopamine seeking feedback loops that other technologies exacerbate. Social media, email, and other apps have created a world in which we have become accustomed to instant gratification anywhere at anytime. When one experiences the smallest absence from these ingrained behaviors it can create a host of undesirable side effects ranging from anxiety, decreased patience, and loss of motivation. I would argue that these environmental factors make it harder to influence one’s reward sensitivity away from these toxic loops when they become increasingly pervasive over time. Perhaps some of the virtues of trading, like patience, were easier to learn before the current technological paradigm began.

Deer In The Headlights

The second system is the behavioral inhibition system (BIS) which governs aversive motivation. Its function is to halt ongoing behavior while processing potential threat signals. It responds to signals of punishment, non-reward, and novelty by increasing attention and halting behavior that may have negative consequences. The BIS stimulates withdrawal from or avoidance of behaviors that may have adverse implications. High BIS activation is associated with increased attention, vigilance, and anxiety. Compared to the BAS, it is argued that BIS activation blocks movement towards goals. The BIS has been linked to avoidant and inhibitory traits such as anxiety and neuroticism, and to states such as negative affect. When faced with the prospect of a potentially negative outcome, high BIS individuals are more likely to freeze. This emotional freezing under stress can also result in less flexibility to volatility and being able to adapt to new market conditions (think of those who longed a market all the way down or shorted it all the way up due to paralysis and fixation on the previous market regime).

Positive shocks unfreeze high BIS investors, inducing them to trade more frequently and generate higher trading profits. However, negative shocks do not alter high BIS investors’ trading behavior significantly. Research has also shown that people who are highly sensitive to punishment signals are more likely to develop negative expectations when faced with adverse stimuli. As the BIS is responsive to signals of punishment, high BIS individuals’ attentional focus is likely to be on the downside potential of risky assets. Negative shocks may simply be interpreted as a confirmation of this downside bias, implying that the effects of this skepticism were already fully reflected in high BIS traders’ pre-shock trading, whereas positive shocks significantly altered behavior and performance.

When looking at reward sensitivity and the BAS/BIS systems, the biggest questions in understanding where you fall as a trader come down to:

• What extent does impulsivity affect your trading?
• When thinking about a trade, do you naturally focus on how much you could win or how much you could lose?
• Have there been instances where a market event or trade has caused you to freeze or create a decision paralysis? If this is a pattern, was it related to positive or negative shocks, or both?
• Does recent positive/negative performance influence your decision making process to take different levels of risk?

Heart Rate Variability (HRV) And Emotional Regulation

“You taught me an average trader makes a trade and feels good; a great trader makes a trade and feels nothing” — Wendy Rhoades from Billions

Though the above quote is intended as hyperbole, there is some truth to the notion that more experienced successful traders feel less intense emotions. In comparison to novice traders, experts have a greater ability to regulate their emotions through attentional deployment and cognitive change. These traders display a willingness to cope with negative feelings in the interests of maintaining objectivity and pursuing longer term goals. Conversely, less experienced traders engage in avoidant behaviors or spend significant cognitive effort in suppressing expression of emotional reactions. Both types of traders have greater difficulty regulating their emotions in volatile markets but more effective emotion regulation is associated with greater experience. The results also suggest that if this is a learning effect, learning takes place slowly. There is also evidence from observing traders’ accounts that traders learn more effective emotion regulation strategies over the course of their careers which is interesting and poses more questions around the role of experience versus the known decrease in impulsivity-related traits that happens with age.

So what’s the best way to quantify and understand these emotional responses in a live setting? Sure it’s great to take some of the questionnaires on risk profiles and impulsivity, or read about these emotional frameworks, but if you’re like me there can still be a gap in implementing techniques of improvement due to the emotional state that volatility or loss can produce. One can make a ton of incremental progress only for an emotional trigger to cause a relapse and regress into old habits, and potentially ruin, similar to how recovering addicts can revert back to their substance of choice when faced with emotional distress. Looking at studies on alcohol, the research suggests that people drink alcohol to enhance positive or manage negative emotional states, and reduce tension, demonstrating the importance of emotional state in impulsive choice. The research further suggests that negative emotions bias behavior toward rushed and more near-sighted decisions, which can lead to detrimental consequences both regarding finance (e.g., retail therapy) and health (e.g., substance abuse).

The goal must be to identify when you are in these different states to isolate problems and structure improvements. This is exactly why learning and acting in a calm emotional state won’t always transfer to the emotionally aroused state. The good news is that measuring emotional responses via physiological cues, such as skin conductance or HRV can help inform mood and better understand risk when making decisions, especially when comparing different levels of market volatility. HRV has been linked to emotion regulation through studies that have collected data on the moment by moment regulation of physiological arousal. To understand more about this connection we need to look at the autonomic nervous system, specifically the sympathetic nervous system (excitatory) and parasympathetic nervous system (inhibitory). These two systems often interact antagonistically to produce variations in physiological arousal. During periods of stability and low stress the parasympathetic nervous system is dominant, maintaining a lower degree of physiological arousal and lower heart rate. During periods of physical or psychological stress the sympathetic nervous system becomes dominant, increasing physiological arousal and heart rate (think fight or flight reactions). Effective emotion regulation requires the ability to adjust physiological arousal on a moment by moment basis. The sympathetic nervous system triggers physiological reactions to internal and external events, while the parasympathetic nervous system effectively shapes physiological reactions to be appropriately adaptive for the context. HRV provides a measure of the moment by moment interaction of the sympathetic nervous system and parasympathetic nervous system, providing information about autonomic flexibility and regulated emotion responding. Thus, HRV can be considered a proxy for the central autonomic network’s regulation by measuring the timing and intensity of an emotional response from a reaction to environmental stimuli. This is the reason why biofeedback is important because it can indicate the state you are in and help detect patterns of risk beyond your normal measured response. It can then allow you to develop an acute sense of awareness during those times and create techniques to either inhibit this state or change your decision-making pattern.

What Should I Be Looking For In My HRV?

Recent experimental studies have shown that higher HRV predicts a lower propensity to framing effects and loss aversion through greater inhibitory control of emotion driven responses. On the opposite end, HRV decreases in response to acutely stressful situations, lack of sleep, and alcohol consumption. This decrease seems to affect the prefrontal cortex, which is the part of the brain that controls reasoning and clear thinking. Translating this over to trading, the first step is to begin measuring your HRV during all trading activity as well as getting a baseline value outside of trading. Once you get a decent amount of data you can start to look at periods of volatility, losses due to good process, and losses due to bad process. From there you can start to make connections between the different HRV values, decisions, and emotional states. There are other areas and criteria that may provide deeper insights, but this is usually a good place to start. I have noticed in my own trading that volatility can trigger a lower HRV, especially if I’m in a position that is against the direction of volatility REGARDLESS of whether it was good or bad process. This was very revealing as it meant that based on my own trading data, I had a higher probability of making a subsequent bad process decision, suggesting that the best decision for me given past data would be to reduce and/or exit the position. The other takeaway that this data has taught me is that it may not be enough for me to just step away from trading in periods of low HRV, but that the critical next step may actually be to raise my HRV via meditation before looking to make the next decision. This was very valuable and taught me that even if I was physically removing my mind from the market, mentally I was still ruminating about it, which in turn brought back the bad mental state when making my next decision.

Tests And Measurements To Better Understand Your Behavior

Through the course of reading the studies cited below, I came across many interesting tasks that the experimenters used on their subjects. Some of these were very revealing and useful to trading so I have included two of them here, along with brief summaries and useful observations that I made while using them.

The most interesting game that I played from the studies was the Angling Risk Task (ART). In this task there is a pond filled with some number of red fish and one blue fish. Each fish has an equal probability of being caught, and the goal is to catch as many red fish as possible which count towards your total score for each round, with the end goal to maximize the total red fish caught over all the rounds. If you catch the blue fish during any round your score for that round reverts to 0, but you are allowed to “bank” the red fish that you’ve caught and end the round whenever you choose. The game also introduces two sets of conditions to make it more interesting: catch & keep/release and weather. Catch & keep, as the name might suggest, means that each fish you catch comes out of the pond, thereby increasing the probability of catching the blue fish and losing all the red fish that you’ve already caught that round. In catch & release the probability of catching the blue fish is held constant, as each fish you catch goes back into the pond. For weather, there are also two conditions: sunny and cloudy. In sunny rounds you can see the distribution of fish, whereas in cloudy rounds this remains opaque, meaning that it is unclear whether you are engaging in catch & release or catch & keep. So between these four conditions, the decision-maker has to deal with increasing layers of uncertainty.

After playing this game several times, I’d say the biggest analogous decision points for traders came from the following areas:

• ART allows you to play at your discretion without setting fixed parameters that programmatically try to collect the number of fish each round. Can you set a plan and stick to it?
• Does the number of red fish you’ve collected in a previous round influence you to deviate from the plan you’ve set? Does catching a blue fish in the previous round create a mentality to take more risk, similar to having a losing trade and trying to win it back?
• Referring back to some of the topics above, are you able to control your impulses and, if not, what are your impulses leading you to do?
• How does your plan change when conditions become more uncertain? In catch & keep the probability of catching the blue fish increases with every red fish that you catch. Do you become more risk-averse or risk-seeking under this condition?
• In the most extreme case of playing with cloudy weather in which you do not know whether the fish are being taken out or released back into the water, how does your strategy change?
• As a final thought on the ART, if catching the blue fish went from forfeiting all the red fish you caught that round (analogous to unrealized profits) to losing red fish you had already banked from previous rounds (analogous to losing some of your principle), how would that affect your initial strategy? What if you didn’t know how many rounds you would get to play in the future? Would that change the risk you are taking in the current round?

Balloon Analogue Risk Task (BART)

BART is very similar to the ART described above, but rather than using fish to keep score, BART has you assign a number of air pumps to a balloon. The balloon will randomly explode at a certain number of pumps less than 128, and the goal is to pump the balloon as many times as you can without causing the balloon to explode. You automatically bank the number of pumps each round in which the balloon does not explode. The biggest difference between the two tasks is that BART is entirely premeditated in that the number of pumps must be assigned at the beginning of each round and there is no discretionary intervention that can take place after the number of pumps has been entered. For me this task allows a greater focus on analyzing how much risk one takes in an environment with less uncertainty and degrees of freedom, thereby making it easier to isolate responses related to risk aversion/seeking and any influence that past round outcomes have on the current round.

I have also included several tests that measure some of the characteristics discussed in this essay based on the responses you give to each question. I will leave the links here for those that are interested. I found these useful in trying to connect trading habits to other behaviors in the rest of my life, informing risk perception, and better understanding one’s personal reward sensitivity.

Finally, I have intentionally chosen not to do in-text citations in the writing above but have included all sources below for further investigation by the reader. The goal of writing this was not academic rigor, but to get the reader to consider how these traits may affect their trading and how best to approach the different emotional frameworks to improve performance. The studies cited may have limitations, including the absence of real world conditions, limited scope, survivorship bias, etc.

Feedback, both critical and otherwise, is appreciated.

Sources:
Reward Responsiveness and Inhibition Traits Differentially Predict Economic Biases in Gain and Loss Contexts
The Dopamine Receptor D4 Gene (DRD4) and Financial Risk-Taking: Stimulating and Instrumental Risk-Taking Propensity and Motivation to Engage in Investment Activity
Fight or freeze? Individual differences in investors’ motivational systems and trading in experimental asset markets
Emotion Regulation and Trader Expertise: Heart Rate Variability on the Trading Floor
Decision Making and Learning While Taking Sequential Risks
Risk-Taking and Impulsivity: The Role of Mood States and Interoception
On Fund Managers, Rats, and Hermit Crabs: Reversion to Familiar Habits Under Stress
The Dopamine Seeking-Reward Loop

Published at Fri, 07 Feb 2020 18:38:00 +0000

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