This is a guest post by Denise Shull from TraderPsyches.
In order to really understand either what went wrong in the credit housing bubble or to improve institutional or individual risk management processes, one really needs to take a step back and rethink their thinking. We tend to believe that we know how we think or even worse, that we know the best way to think (after all didn’t we go to college to learn to think?) but given the advances in brain science in the past decade it is clear that we really don’t know how it is we think.
Thinking is germane to analysis and decisions and in turn confidence and beliefs are germane to implementing a decision. I still can think of no better way to say it than Colin Camerer of Cal-Tech and his co-authors Lowenstein and Prelec when they said “It is NOT ENOUGH (emphasis mine) to know what SHOULD be done, one must also FEEL it.” Well invert that and you get that all doing has a feeling associated with it.
Now Damasio and Bechara showed us this from The University of Iowa and USC starting in the early 1990’s but word really hasn’t hit Wall Street (or Washington either btw). Behavioral finance observations confirm that we indeed feel better when we rely purely on mathematical formulas but the real world doesn’t always fit into an equation.
And guess what – our brains (particularly on risk) know it! On the majority of days, it works fine to do it the old way. But doing well in the middle isn’t what makes you the real money or saves you from the black swans – that requires knowing what to do when things DO NOT go according to plan.
The solution lies in using our “maths” within the context of consciousness about the foundational and relevant qualitative data. Our brains are good at pattern recognition – call it implicit learning or intuition – it is the same. The problem is we don’t value that data – partially because we don’ t know how. In fact not all that long ao it wasn’t blink and Malcolm Gladwell getting $100K to talk about it, it was only “feminine intuition.”
The key tenets to build an integrated decision making system for risk and the markets?
1. Never forget that you are betting on what other people will perceive about the same bet in the future
2. Know that they think a whole lot like you (whatever level you are at).
3. Ask yourself how your tools and formulas help you better understand their future perceptions. (Btw that is called Theory of Mind or Mentalizing in the scientific world).
4. Ask what can you do to improve your models and algorithms to better reflect the likely decisions of the competition. An example in the trading world is learning to use, read and interpret volume – particularly volume at price.
5. Next look inside – ask yourself what beliefs you bring to your risk decision. Get them out in the open because they have the amazing ability to create unrecognized biases.
6. Ask that question about your beliefs and the market and about your beliefs about your role right now in decision making. The latter will lead you to your own self-perception and its possible coloration by past experiences having nothing to do with trading or risk decisions. The latter is personality and life based.
Yeah you could call this the touchy-feeling approach to risk management (I suppose) but see the thing is, your brain is using context, pattern matching, probability judgments about the unknowable – and therefore so should you! Work with it – not against it.