Thursday, June 22, 2006

numerical models of emotional states (part 1)

REAL . 10 | -10
FAKE ... 2 | 1

Everybody has a pyschological payout grid, but everybody's grid is different. Payout grids are a helpful tool in understanding both the broader cyclical rhythms of financial markets and the specific characteristics of individual traders.

To review, the psychological payout grid has four squares. The first line in the above example deals with the real world and real risks. For the person described by the above grid, if the trade succeeds, there is a positive psychological payout (10). Similary, if it fails, there is a psychological cost (-10). The second line shows the risks and rewards of thinking about doing something rather than actually doing it. If the trade would have succeeded, the above person can feel smart for having thought about it (2). If the trade would have failed, that person can feel smart for not doing it (1). This particular payout grid shows that a fantasy life can sometimes have more edge than a practical one.

If we assume that psychological payout grids vary genetically and psychologically, then we should be able to figure out what types of people would succeed in different types of markets. Needless to say, a person with an active fantasy life will probably shun trading as a career, so it makes sense that even moderately imaginative people can carve out a nice living on the fringes of the financial community, because creativity is both necessary and selected against in the field itself. The universe abounds with exceptions, and one of the most brilliant traders I know experiences a negative psychological payout from fantasy success, which drives him to action.

As a rule, however, people initially attracted to the trading profession derive higher psychological payouts from winning, with lower psychological costs from losing, and no psychological benefits from their fantasy life. Indeed, if you have had the pleasure of being on a trading floor during a bull market, that sort of imbalance would describe most of the floor traders (unimaginative optimists). Given that reinforcement encourages behavior, one can model the different pyschological profiles of different market participants during different types of markets, and while these composite psychological profiles will not forecast market direction, they can be used to predict market tone.

So, as the market shakes out, it favors people with opposite psychological architecture. Those who experience extreme costs for losing, but maintain an even psychological equilibrium when they win, have a higher incentive to avoid losses. They learn by obsessing about their losers, and find ways to avoid them or even make them profitable (i.e., going short). In general, the market participants who survive in the medium term are hypercritical -- with their bearish instincts often honed on their earlier optimism.

At the top of the financial community, however, people leave their emotions behind, and observe market tone rather than create it. The famous line about Stephen Cohen, that "if you watch him in his trading room, you can't tell if he's having the best day or his life or the worst day of life" is pretty much true about all the great traders. Such people have often gone through the entire cycle: they start as unimaginative optimists (bulls), become hypercritical pessimists (bears), and then spend their peak years as cheerful automatons, living in a flow state of pure activity.


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