Do phantasy, paranoia, schizophrenia and testosterone hold the true keys to trader performance?

By Hamlin Lovell

In the renaissance, it was common for people to practice five or six different professions. That was perhaps before every profession became a conspiracy unto itself, as George Bernard Shaw said. Is it possible that many finance academics, having spent decades inside the efficient markets paradigm, have become equally blinkered by behavioral finance, which also needs to spread its wings and embrace other subjects to more fully explain and understand investor performance?

That is the contention held by psychoanalysis professors looking at finance (who were first highlighted by AAA here and here) and neuroscience specialists may also be able to enlighten the analysis of trader performance.

Behavioral finance, they say, is grounded in cognitive psychology, which assumes people are conscious of their decision making processes –  but simply make the wrong decisions, due to drawing incorrect inferences. Yet to really grasp what lies behind investor behavior do we need to delve deeper into the subconscious mind, and the biochemistry of human hormones?

Starting with the “shrink”, writes David Tucker in his latest research here

“bubbles develop because excitement about new prospects becomes divorced from anxiety that values might be exaggerated”. He goes on to explain how the normal calculus between risk and reward is overwhelmed by a “phantastic object”, which is not fantasy mis-spelled. The concept of seeing fantasy as reality stems from psychoanalysis, leads to emotional anxieties being suppressed into the subconscious mind of our grey matter, and is also cited as the culprit of intelligent people who could only see blue sky outcomes investing with Madoff. This pattern can only occur when the mind is in a divided, paranoid-schizoid state.The good investor therefore needs an integrated state of mind to avoid being in denial about anxieties that should be uppermost in their mind.

Figure 1: A Divided Mind Creates Bubbles

Source: AAA staff, created using models described in cited text

The first chapter of Tucker’s new book is available here and carries the imprimateur of having been read by the current Governor of the Bank of England. Mervyn King.  None other than hedge legend George Soros has also met with the author, as has UK financial regulatory supremo Lord Adair Turner.

Neuroscientists John Coates and Joe Herbert agree with Tucker and Taffler that the risk taking process is not purely cognitive, and even suggest that cognitive component is only “the tip of the iceberg”. Whereas Tucker finds a psychoanalytical rationale for behaviour, Coates and Herbert go one step further in trying to identify the body chemistry behind the psychology. This paper documents how they monitored their guinea pigs’ (proprietary traders paid purely on profits ) saliva samples and found testosterone and cortisol to be the relevant “endogenous steroids”, or hormones produced inside the human body. Just as winning athletes enjoy a surge of testosterone, the same hormone levels shoot up with a traders’ daily profitability. This perhaps makes sense of some trading floor rituals where traders vie for the title of Master of the Universe, or still worse, Big Swinging Dick.

Figure 2: How Hormones Drive Traders And Athletes

Source: AAA staff, created using models described in cited text

Cortisol (which aids response to challenges) by contrast came into play when traders were faced with adversity: either when their own profit and loss became more volatile, or simply when markets in general did so. The correlation between cortisol levels and the implied volatility of German bunds was astonishingly high at 86%.

The bridge between this work and behavioral finance is that the paper points out both hormones are known to have cognitive and behavioral effects. So cynics may say we have merely made an amusing journey that has made one circular orbit back to behavioral finance where we started.

Yet it is far too early to subsume this new research under the BF umbrella. All of the researchers involved admit that their work is in its infancy.  Generations ago the great banker Siegmund Warburg was known to employ handwriting analysis as part of his recruitment process. Maybe he was seeking to assess whether aspirant bankers had the right emotional make up, and this new research might codify more precisely the emotional and hormonal composition that create great alpha generators.

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