“Buy to the sound of cannons, sell to the sound of trumpets.”

—Attributed to British banker Nathan Mayer Rothschild, during the Napoleonic wars ¹

An investment banker friend of mine is no stranger to high stakes. He frequently negotiates deals worth hundreds of millions of dollars with multiple competing parties.

In early 2006, he was negotiating to purchase a small mining company for a client. A deal had been hashed out at terms that were very favorable for his team, and the consensus was to close the deal the following day. For $220 million his client would take control of significant land holdings with mineral rights, an operating metals mine, and a small prospecting division.

The night before the deal was to close, my friend couldn’t sleep—not even a wink. Initially, he didn’t know why, but by 3 A.M. he had an inkling. Early in the morning, he called the other party and canceled the deal.

Initially, his colleagues were incredulous. The deal had been agreed. How could he renege without consulting them?

He asked them to keep their cool. He had a hunch. He requested that they make no phone calls and discuss nothing with their counterparties. “Zip it,” he told them.

Twenty-four hours later, the seller’s broker called back offering a 10 percent discount. The new papers were drawn up (with a new price of $198 million). He got a good night’s sleep the night before the signing, and the deal was closed the next day.

How did he know that they hadn’t been getting the best possible terms? “I can’t say,” he told me. “When these things happen, I don’t think about it; I just go with it.” He explained, “I knew that if I wasn’t sleeping the night before the deal, then I had to call it off. I wanted us to keep our heads down for a few days until we heard from the other side. And the other side gave in . . . like I suppose I figured they would.”

He had a hunch he wasn’t getting the best deal for his clients. His body told him something was wrong before he was consciously aware of what it was. By listening to his physical sensations (and his inability to sleep), he was able to infer an optimal strategy as events developed. He made an intuitive decision—one that he couldn’t rationally explain—that turned out to be extremely profitable.

ANALYSIS AND INTUITION

Nobel Prize winner Daniel Kahneman postulates that there are two broad neural systems underlying decision making: the analytical and the intuitive. Analytical judgment is primarily logic based, while the intuitive system is rapid and feeling based.

This chapter describes the process of optimal intuitive decision making in market-like conditions—risky, uncertain, and with performance expectations and time pressure. If the mind is well managed, these conditions are optimal for the flourishing of intuitive decision making.

Intuitive decisions rely on “gut” knowledge. This chapter demonstrates how listening to one’s “gut” has tremendous advantages (and potential dangers) for market participants.

Ancient Greek conceptualizations of emotion assumed that feelings should be tightly controlled, lest they disturb rational thought and deliberation. Even today, it’s tempting to speculate that if everyone were fully rational and analytical, the world would be better off. This idea conjures Mr. Spock, the character in the Star Trek television series who was half Vulcan. The creator of Star Trek, Gene Roddenberry, designed Vulcans as an advanced humanoid race who struggled mightily to make decisions based solely on logic.

In the Star Trek series, Vulcans suppressed emotional influences by living lives of rigid self-control. Vulcans relied on meditative techniques and mental discipline to keep feelings from influencing their judgment. But like humans, Vulcans could not entirely escape emotions in order to live by logic, so they established elaborate rituals to channel and safely release emotional and sexual energies. Vulcans periodically returned to their home planet for a well-guarded annual rite in which they yielded to an all-consuming catharsis of emotion. Additionally, episodes of Star Trek routinely ended with a conciliatory vindication of human emotion as opposed to cold Vulcan logic.²

So how do humans integrate “messy” emotions and “soft” intuitions into a rational decision-making process?

INVESTMENT PRACTICE

Traditional investment theory assumes that people use reasoning and objective analysis during decision making. According to traditional theory, investors slowly and mechanically judge potential outcomes, weighing their probabilities and their potential gains or losses, to arrive at a rational analytical decision. They arrive at a choice after a series of calculations—a “risk-reward analysis.” Yet, in a world where ultimate outcomes are uncertain and volatility can arise unexpectedly, investment practice is not as rational as theory suggests. Currently, however, there is no single coherent psychological theory to counter the assumption of investor rationality.

What I see in my coaching practice is professional investors following primarily reason-based judgment—with an important dose of intuition (gut feel) injected just before the actual choice. Many of the best portfolio managers initially perform a rational analysis of known facts and figures. They gather information from corporate management, customers, suppliers, employees, and stock analysts. But in order to consolidate all this complex information into a single decision, they use an intuitive process. They sum up all this information by asking themselves, “Does the investment ‘feel’ right?” More often than not, intuitive “gut feelings” guide some aspects of the research and determine the ultimate buy or sell decision.

Fortunately, the first part of the investment decision-making process can be controlled. Many investors define the indicators they are looking for in advance (called their “investment philosophy”). Once they collect the quantitative information, they perform a disciplined and objective analysis of the facts at hand. Most beginning investors fix their attention on one or two positive or negative factors and make their decision. But often the best investors go one step further. The best pay attention to and are guided by their feelings about certain aspects of an investment. They may be uncomfortable with cash flow volatility or off-balance-sheet transactions, so they ask their analysts to dig deeper. They may have a positive “aha” feeling about the potential of a company’s products. Perhaps they feel that most analysts’ forecasts are too cautious, and they use that information to weigh in favor of buy decision. However intuition comes into play, it is far more widespread in investment practice than most theorists concede.

WHAT DOES YOUR “GUT” TELL YOU?

The human senses relay about 10 million times more pieces of information per second to the brain than can be consciously perceived.³ How can the brain possibly process all this data? The brain uses simplifications and shortcuts to facilitate information processing.

The vast majority of our daily decisions are intuitive decisions—decisions made rapidly, automatically, and beneath conscious awareness. Intuition and “gut feel” often underlie some of our most consequential decisions. Intuitive decision making is honed unconsciously, through experience, and it is the foundation of more than 90 percent of all decisions.

Too often, deliberately keeping track of intuition doesn’t work. Part of its grace and simplicity is that it operates subconsciously, not accepting input from higher cognitive levels. Thinking about a decision brings the process into conscious awareness, and such conscious deliberation drowns out important aspects of the fragile intuitive process. Without practice, if one consciously tries to tap intuition when making a decision, he or she usually fails.

In business, deciding from “the gut,” especially for experts, is a common way of handling decisions with uncertain outcomes. “The gut” refers to an experienced and intuitive consideration of the current situation. This intuitive “hunch” comes to attention as a feeling, as in, “I’ve got a good feeling about this.” This feeling represents a subconscious emotional process that is manifested in physical sensations.

Some business leaders credit their style of intuitive “gut” decisions with their success. Former General Electric CEO Jack Welch even entitled his autobiography Jack: Straight from the Gut. Outcomes in the business world are high stakes and inherently uncertain, an ideal environment for integrating intuition and expert judgment.

Some experienced investors, such as George Soros, are intuitively tuned into subtle physical cues. George Soros is a Wall Street icon for his outstanding long-term performance. Anyone who had invested $1,000 in his Quantum Fund when it opened in 1969 would have realized a cumulative 30-plus-percent annual return (about $4 million) by the turn of the century.

Soros occasionally uses the physical cues of intuitive hunches to inform his strategy. George Soros’s son remarked that “the reason he changes his position on the market or whatever is because his back starts killing him. It has nothing to do with reason. He literally goes into a spasm, and it’s this early warning sign.”⁴ Soros can observe his physical sensations to aid his decision making, much as other experts use “gut feeling” or “hunches.”

Soros generates investment plans by integrating both his intellectual theory of market action and his somatic (bodily) sensations. “According to Soros, his theory informs his decisions, and his body gives him the signals.

The making of a self-reinforcing trend brings water to his mouth. The need for a portfolio shift makes his back hurt. His body ‘knows’ he needs to take action, or to take careful note of a situation before his intellect can grasp it.”⁵Soros is tuned in to subtle somatic sensations reflecting potential risk and opportunity. Importantly, he does not operate solely based on intuition; rather, he utilizes his physical sensations to complement an analytical assessment of market price action.

Trading coach Doug Hirschhorn administered the Myers-Briggs, a common personality test, to a large group of portfolio managers. The personality trait Intuition (N) was present in 80 percent of portfolio managers and 25 percent of analysts. This differential suggests a separate skill set. Portfolio managers were more likely than analysts to follow an intuitive decision process rather than relying on explicit data.⁶

Intuition isn’t always easy to follow. Sometimes strong emotions drown out gut feelings. Several factors generate emotions that overwhelm intuition. Feelings that result from remembering, experiencing, or anticipating large gains or losses will negatively bias intuitive judgment. Any environments in which one is under significant time, social, or performance pressure (such as within contentious investment committees or when considering one’s performance at the end of the fiscal year), can easily bias intuitive judgment. Fortunately, quiet reflection can open one up to the intuitive consideration of complex information.

LISTENING WITHOUT THINKING

As you’ll see in the example below, detachment from memories, expectations, and current pressures facilitates the unfolding of the intuitive process. Here’s how one top hedge fund manager described his investment decision process. The following are my notes from our talk.

Peterson: How do you know what to invest in?

Investor: I just feel a lot of information. I gather it all up and then I sit on it. Like an information sponge most of the time—really, like a sponge. I’m not trying to do anything with it [the information]. I’m not looking for answers, I just sit on it, and when the time is right, it comes to me. I’ll feel a little tickle that tells me to pay attention to something, like a tiny ‘look at that’ kind of feeling. I don’t know what I’m looking at exactly, but I just pay some more attention to it.

Peterson: And how does that translate into action?

Investor: Often without knowing why, I start planning deals. It may be to buy shares in an Indian refrigerator manufacturer, or a pipeline, or mineral rights in Peru. Who knows what the inkling will lead to? But that’s how it works. It’s like I step out of the way. I can’t have distractions, I can’t think too much about it, or explain how I do it. I just get into the zone and I don’t get out of it until I do what the feeling is compelling me to do.

Peterson: Those are pretty diverse examples. Where do you get your “intelligence” about so many different industries?

Investor: The information I take in is workplace stuff—strategic and financial information that my traders and analysts bring me or that I see over the terminals. Nothing more than what everyone else is seeing, except that I’ll go, or send someone to go, to get deeper information when I feel the need for it.

This investor is acting like an information filter, allowing his intuition and experience to identify patterns and setups that other investors have overlooked or not yet identified. If he were to consciously think about the information he is looking for in detail, then he would lose the ability to be “in the zone.” Notice that he’s maintaining mental equanimity during this process. He’s not recalling past deals or thinking about how much money he might make or lose. Rather, he pursues his inkling with open curiosity, which leads to a general idea, which directs him to an opportunity.

INTUITION AND EMOTION IN INVESTING

“I had no business to think because my business is to trade—that is, to stick to the facts before me and not to what I think other people ought to do.”

—Edwin LeFevre ⁷

In simple decision-making situations, conscious thought usually leads to better decisions, but after a certain level of informational complexity is reached, the quality of conscious choices falls below that of affective choice. Feelings provide mental shortcuts, allowing people to quickly and easily judge the “rightness” and “wrongness” of complex scenarios.⁸ According to Professor Paul Slovic’s theory of the “affect heuristic,” briefly introduced in Chapter 3, decision makers usually rely on affective (emotional) meaning to guide judgments and decisions in everyday life. All of the images in a person’s mind are tagged to varying degrees with affect. The “affect pool” contains all tags that are consciously or unconsciously associated with the images. Since affective information remains readily available in a pool of tags, it can generate quick and easy reactions to a host of familiar stimuli.

Emotion, via the affect heuristic, can act as information to help form judgments. It can serve as a generalization shortcut, allowing people to rapidly sort through and integrate multiple pieces of related information. Affect can also help people focus on salient or relevant aspects of a decision. Finally, affect is motivating, leading to faster and more determined decisions.⁹^,¹⁰

Affect is thus an essential aspect of daily decision making, where it supports the subtle processes of intuition. Unfortunately, when affect is biased by “special interests” (strong emotions generated by the brain’s comparator), its effects on financial decisions can be problematic. When emotions are powerful, especially when produced in anticipation of, recall of, or reaction to external events, they can overwhelm intuition and negatively bias judgment and decision making. In order to distinguish which affects (emotions) are helpful and which are potentially biasing, it’s useful to turn to the insights of psychologists who study emotional intelligence.

EMOTIONAL INTELLIGENCE

In order to harness the power of gut feel while avoiding indulgence of emotional “special interests,” an aptitude called “emotional intelligence” can be developed. The study of “emotional intelligence,” pioneered by business psychologist Daniel Goleman, arises out of evidence that emotional competencies are more conducive to business success than purely intellectual IQ.

According to Goleman, emotional intelligence refers to “the capacity for recognizing our own feelings and those of others, for motivating ourselves, and for managing emotions well in ourselves and in our relationships.”¹¹ There are five basic emotional competencies that together comprise one’s emotional intelligence: (1) self-awareness, (2) self-regulation, (3) motivation, (4) empathy, and (5) social skills. In a study of executives at 40 companies, strength in emotional intelligence was more prevalent among “stars” on the job (53 percent) than intellectual intelligence (IQ) or subject expertise (27 percent).¹² It is possible that high emotional intelligence correlates with investing success as well, but I am not aware of any scientific studies on that issue.

SUBLIMINAL EMOTION

One of the skills essential to emotional intelligence is self-awareness. If people are not aware of what they are feeling, then they cannot distinguish helpful gut feel from biasing emotions. Such subconscious emotions can be dangerous because they alter how people think about financial opportunities and risks. Furthermore, self-awareness of such emotions requires a high level of expertise.

Researchers have found that emotions induced by one event will color how we think about other, unrelated situations. Emotions induced by watching movies, enjoying sunny weather, or experiencing stressful exams have been shown to influence judgments of unrelated topics and objects.¹³ For example, in one experiment, participants who read happy newspaper articles subsequently made more optimistic judgments about risk than those who had just read sad articles.¹⁴

Perhaps frighteningly, there is solid scientific evidence that people are often not consciously aware of what they are feeling or its likely effect on their judgment. Professors Winkielman and Berridge, at the University of California-San Diego and the University of Michigan, respectively, performed a series of experiments in which participants were subliminally presented with a happy face or an angry face and then asked to pour, consume, and value a beverage. “Subliminal smiles caused thirsty participants to pour and consume more beverage (Study 1) and increased their willingness to pay and their wanting more beverage (Study 2). Subliminal frowns had the opposite effect.” Participants reported no change in their subjective feelings resulting from the subliminal smiling or frowning faces.¹⁵ Yet even though they felt no different after seeing the faces, their financial behavior changed.

STIRRING THE UNCONSCIOUS

In a study of subliminal emotion during financially risky decisions, Professors Trujillo and Knutson at Stanford University designed a study in which subjects decided among risky options after viewing a photo of an emotional face. ¹⁶ The faces were expressing prominent emotions such as fear, anger, or happiness. Participants were asked to name the gender of the face before proceeding on to the gamble, to ensure that they had been paying attention, though they were not warned that the facial expression might affect their decision making.

The researchers ran three experiments in which subjects chose between different risky financial options. Interestingly, but unsurprisingly, participants were most likely to select the riskiest option after viewing happy faces. However, after an angry or fearful face was viewed, participants were more likely to choose the safe option. There were no differences between effects of anger versus fear. However, viewing an angry face decreased the likelihood of investing on the subsequent trial.

Importantly, the faces’ emotional expressions influenced participants’ decisions regardless of their performance feedback (how much money they made or lost). In general, positive expressions (happiness) increased risk taking, while negative expressions (anger and fear) decreased it. Furthermore, happy faces increased risk taking (when measured in terms of payoff variability), even when there was no advantage to be gained by taking more risk. In conclusion, the researchers speculated that transient subconscious activations of the brain’s fear (amygdala), anger, and happiness (nucleus accumbens) processing centers biased the ability of the cortex to correctly value risky gambles.

Investors are probably affected by other sources of unconscious emotions, besides faces. The workplace mood, the tone of business news broadcasts, the content of the morning newspaper, and one’s home emotional environment may all be factors that unconsciously bias how one approaches risky decisions. Even if the influence of these factors is small, a 1 percent alteration in risky choice can lead to a large cumulative gain or loss over years.

This chapter has emphasized the value of intuition in expert investment decision making. Yet the pitfalls of overthinking, strong emotional biases, and subliminal emotions render intuitive judgment excessively biased for most investors. Experience (gained through honest appraisals and rapid feedback) and emotional intelligence (specifically self-awareness) are the remedies that excellent investors use to fortify the intuitive process. The emotions that bias intuition lead to characteristic financial mistakes. The next chapter will describe in detail the specific effects of emotions on financial judgment.