CHAPTER 10

“I can put my hand on my heart and say I don’t get stressed out by the markets.... I’ve seen people get very stressed, and if you’re stressed, you can’t do this job effectively.”

—Christian Siva-Jothy ¹

Successful portfolio manager Jon Brorson was profiled in the Wall Street Journal in the summer of 2006.² He had made a good call for his investors at Neuberger Berman in May 2006, shifting toward “defensive” stocks before the market took an 8 percent plunge that month. As the Wall Street Journal put it, “When the market cracked in mid-May, he was exultant, as his move to caution had put him ahead of the more bullish competition.” Yet Brorson remained defensive, missing the market rebound in late summer and early fall of 2006.

Brorson was growing worried as the market climbed. The market’s price action contradicted his expectations, and he felt that he was missing out. As the Dow hit new all-time highs, Brorson became increasingly distressed—immersing himself in information via his two trading terminals, CNBC, and his analysts. Throughout September he worked long hours and slept poorly. As CNBC floor commentators called the market’s mood “optimistic,” Brorson muttered disagreement, “Time to sell. Time to sell.”³ Brorson and his associates believed that third-quarter earnings could disappoint, so they decided not to chase winners in the weeks before earnings, choosing instead to wait until late October to jump back in.

Brorson was experiencing escalating stress. Unaccustomed to falling behind, he now found himself in a market that contradicted his expectations and beliefs. He decided to allow an external criterion (earnings) make his timing decision for him. But he found himself psychologically trapped—he needed his fund to at least stay even with the market, inclining him to chase securities upward, while simultaneously trying to wait for the anticipated negative earnings reports, after which he could pick up bargains. Because of his dilemma—being caught between his own expectations and the contradictory behavior of the market—he was unable to relax until either (1) the market sectors he disliked dropped or (2) he capitulated and bought rallying stocks.

STRESS

“Stress is the condition that results when person-environment transactions lead the individual to perceive a discrepancy—whether real or not—between the demands of a situation and the resources of the person’s biological, psychological or social systems.”

—Edward P. Sarafino ⁴

Stress arises out of the discrepancy between where one is and where one imagines they should be - a conflict between their expectations and reality. If that difference is too large, for too long, chronic stress will physically wear them down, leading to burnout. Anxiety, antagonism, exhaustion, frustration, distress, despair, overwork, and fear are all types of stress.

There is an important distinction between different intensities of short-term (acute) stress. At low levels acute stress can be motivating: it stimulates activity, sharpens attention, and enhances goal focus. Additionally, brief episodes of high or moderate stress, such as experienced during an amusement park roller-coaster ride, can be exhilarating. However, at extreme levels, acute stress often induces an overwhelming “fight-or-flight” urge (panic).

Prolonged high stress leads to a number of negative physical and mental consequences. Such chronic stress impairs short-term memory and concentration and promotes hypervigilance—too often leading to interrupted sleep, high blood pressure, and adverse metabolic effects. Chronic stress contributes to accelerated aging, decreased immune function, depressed mood, apathy, and diminished energy. Eventually, chronic stress results in “burnout.”

Many traders experience chronic stress at work. A common saying relating traders’ stress to its physical consequences is that, “Traders age in dog years.” As if for each year of trading, that trader ages seven years. The rest of this chapter will examine investment stress, its neuroscience, consequences, and strategies for reducing its adverse effects.

CRAMER ON STRESS

On March 11, 2000, days from the all-time high of the NASDAQ, Jim Cramer published a rewrite of his wife’s 10 trading commandments on TheStreet.com. Her fourth trading commandment addressed the paralysis accompanying extreme stress—a consequence of unbearable losses:

If you feel like a position of yours is going to drown you in your own pool of losses, please the trading gods and throw a maiden in the volcano.... (I can’t tell you how important it is to have your head clear. The only way to clear it when you are having the &(&*%*% knocked out of you is to take a small loss. It loosens the vise and allows you to think again. You need to be clear-headed to make money. If there is a position that is dogging you, take some of it off, throw the maiden in the volcano and please the gods. This is not as silly as it sounds. You will breathe regularly and you will be able to make a better decision. Also you will have your eyes open for the next big chance.) [original bold]⁵

CHOKING FOR RUPEES

Dan Ariely is a psychology professor at Harvard where he frustrates (with brain puzzles), shocks (electrically), freezes (in cold water), and otherwise stresses out his student volunteers. None of his experiments threatens permanent damage, but they do have interesting effects on participants’ state of mind. Ariely induces and Cramer describes market-style stress.

In high-pressure environments, where a lot of money is at stake, why do many people “choke”—underperforming their actual abilities? Ariely was curious about the effect of financial incentives, such as end-of-year bonuses, trying to close a large deal, and stock market gains and losses, on individual performance. The conventional assumption was that higher pay leads to better performance in such incentive-based decisions, but Ariely suspected that such an assumption is inaccurate.

When designing an experiment to investigate choking, Ariely quickly realized that he couldn’t afford to run the study in the developed world. He thought salaries in the United States and Europe were too high for his meager research budget to make an impact on subject decision making. Having already developed a network of university students in India, Ariely traveled there to run his experiment in one of his students’ home villages (where average salaries were incredibly modest). Workers in the chosen village spent, on average, $10 per month.

Ariely designed his experiment so that subjects would play one of several different types of games. Some required superior cognitive skills, and others demanded physical performance in the effort to earn a large jackpot. The highest-paid players could earn several weeks’ expenses based on one outstanding performance. They could earn a total of six months’ expenses if they executed the tasks perfectly. To his subjects, Ariely’s financial rewards seemed enormous.

Ariely divided the subjects into three groups. In each task, the first group received 0 Indian rupees (Rs) if they performed poorly, 2Rs if they did “good,” and 4Rs if they had “very good” results. The second group played for 0Rs, 20Rs, or 40Rs depending upon their performance, while the third group could win 0Rs, 200Rs, or 400Rs. The third group was playing for, relatively speaking, very high stakes. (Approximately 45Rs equal US$1).

Subjects played several different tasks, including the classic memory game Simon, the concentration game Labyrinth, and the motor skills game Dart Ball, among others. Subjects played each game 10 times. They achieved “very good” performance if they accomplished a predetermined success criterion. Eighty-seven subjects participated, with one-third selected randomly for each payoff group.

Ariely found that participants in groups 1 and 2 had a statistically similar rate of achieving “very good” results, approximately 30 percent of the time. However, participants in group 3, who were playing for several weeks’ expenses in each game (the equivalent of over $2,000 for the average American), performed worse than the other groups, achieving “very good” performance only 10 percent of the time. Playing for high stakes sabotaged their performance.⁶

In many experiments where subjects make large amounts of money, they often relax their attention as their wealth accumulates, decreasing the rate of their earnings. Interestingly, Ariely found no such “wealth effect.” Subjects in Ariely’s experiment who initially earned large gains did not experience performance reversals during the later tasks.

Outsiders who were asked how they thought people would do in Ariely’s experiment predicted that performance would improve as the amount of money at stake increased. In general, most people are unaware that stress over high stakes will adversely affect their performance. If they had such insight, they could take preemptive action against excess stress—performing relaxation exercises or using cognitive reframing techniques.

Among some financial market professionals—investment bankers closing large deals and negotiators for single high-stakes outcomes—choking is more likely. In many ways, “choking” stress is purely perceptual: we think that stakes are high, but as in Ariely’s Indian experiment, “high” stakes are relative to one’s context and experience.

WHICH GOES WRONG—THE BRAINS OR THE BRAWN?

Ariely had found that performance stress caused “choking” among the most highly rewarded subjects. Yet it wasn’t clear to Ariely whether stress was impairing the subjects’ cognitive or physical performance. For example, it was possible that stress did not impact their thinking, but rather it impaired their dexterity and motor coordination. In order to verify his results in the developed world and clarify whether the decreased performance was primarily due to the motor or cognitive effects of stress, Ariely designed a new experiment for Massachusetts Institute of Technology (MIT) student volunteers.

In the motor task, subjects were asked to type a series of letters on a keyboard as rapidly as possible. On the cognitive task, subjects were asked to find two three-digit numbers (e.g., in the format 1.23) whose sum was 10. These numbers were hidden within a 3 × 3 matrix of like numbers. Students with “very good” performance on either the motor or the cognitive task could earn $300.

Ariely found that as task payoffs increased, motor skills increased, but cognitive skills decreased. Importantly, subjects performed worse at the mathematics task when more money was at stake.⁷ According to Ariely, this cognitive decline when under stress is due to a shift in decision-making strategy. Under stress, the brain shifts its processing and decision functions from “automatic” to “manual” control. “Manual” control implies that the participants are overthinking their task strategy. The brain’s realignment to a “manual” strategy is unconscious and very difficult to reverse once play has begun. Recall that a similar effect—the distortion of intuition by conscious analysis—was discussed in Chapter 5.

As stakes increase, investors have trouble using smooth intuitive decision making. When they realize that the amount of money at stake in their investments is larger than ever before, they can easily lose their focus and concentration. They inadvertently shift from automatic to manual cognitive control, and this shift ruins their ability to fluidly respond to market events.

In a third experiment at MIT, Ariely examined the role of social observation on performance. Participants were asked to solve anagrams (mixed-up collections of letters that spell a word when decoded) either at private cubicles or on a blackboard in front of three people. Performance was rewarded financially. Subjects who solved the puzzles in private solved 1.16 anagrams per minute, while subjects who solved publicly figured out only 0.67 per minute. Being observed had a strong detrimental effect on cognitive performance.⁸

Many financial planners, advisers, brokers, and portfolio managers experience the stressful effects of observation on their performance. When clients are closely watching a manger’s gains and losses, the manager’s investment skills are likely to be constrained. Besides the disproportionate time they require, this may explain why nervous and controlling clients are so irritating to many financial planners.

Hedge fund managers who utilize a two-year lock-up of client funds may feel less social pressure, though quarterly reporting requirements prevent true independence from client observation.

STRESS AND TREND PERCEPTION

The following study demonstrates that stress intensity is not only proportional to how bad things actually are. In fact, much of the stress response is generated by perceptions of a worsening in conditions. A “really bad” situation that appears to be improving to “pretty poor” status provokes relief, while a “neutral” situation that is worsening toward “poor” can be quite stressful.

Researchers examined the stress responses of two groups of rats after they were subjected to painful electric shocks. Group 1 received painful electric shocks 10 times per hour, while Group 2 was shocked 50 times per hour. The second day, all rats were shocked 25 times per hour. At the end of the second day, rats from Group 1 (who experienced an increase in shock rate) had elevated blood pressure (a physical sign of stress). Rats from the second group (who experienced a decrease in shock rate) had normal blood pressure.⁹ Why the difference?

The rats were responding to the perception of a worsening or improving situation. The Group 1 rats were in a worsening situation. On day two, the rats in Group 1 were stressed to experience 25 shocks per hour, while the Group 2 rats were relieved to be subjected to the very same event.

In the markets, if investors believe that the economy is going from bad to poor, they may feel relieved and subsequently buy stocks. On the other hand, if they believe that the economy is going from neutral to poor, then they will feel stressed and will prepare for increased economic risk by selling stocks. Perceptions of future stress are felt now.

NEUROCHEMISTRY OF STRESS

When people worry or get stressed out, their bodies secrete chemicals that prime them to fight, flee, or perform other quick evasive actions. Animals under stress relieve their discomfort by acting, but humans are usually left to simmer in their stress hormones, often never acting out in a way that relaxes the stress response.

The psychological effects of acute stress response are often adaptive: “If you’re in dangerous conditions it helps to be distractible, to hear every little sound in the woods and react rapidly, instinctually.... It’s like getting cut off on the highway. You don’t want to be a slow, thoughtful creature.... You want to react and hit brakes.” ¹⁰

Chronic stress results from a series of acutely stressful events that chemically “prime” the body for adverse circumstances. Over time, the bodies and minds of the chronically stressed adapt to the chemical priming agents, resulting in the negative physical and mental effects described below.

The chemistry of the human stress response is understood as resulting from two primary brain pathways. The immediate stress response prepares the body for urgent struggle. Within seconds the sympathetic nervous system (SNS) is activated. A small nerve bundle in the brain stem called the locus ceruleus (see Figure 10.1) releases norepinephrine, triggering a cascade of physical preparations for struggle. The SNS is a network of nerve fibers running to large skeletal muscles, the heart, the skin, the diaphragm, and the sphincters (among other areas). When SNS nerves fire in alarm, physical signs such as trembling, perspiration, rapid heart rate, shallow breathing, and pupillary dilation occur. The SNS is responsible for the physical reactions to acute stress and panic.

The second neural pathway manages the stress response over minutes to hours. During acute stress, a signaling hormone is secreted from the hypothalamus, which travels via the bloodstream to the pituitary gland where it triggers the release of a second hormone, adrenocorticotropic hormone (ACTH). Via the bloodstream, ACTH travels to the adrenal glands, where it triggers the release of cortisol and epinephrine (adrenaline). The hypothalamic-pituitary-adrenal (HPA) axis is the control structure of the chronic stress response, involving the interactions of the hypothalamus, the pituitary gland and the adrenal glands.

FIGURE 10.1 Hypothalamic-pituitary-adrenal (HPA) axis. The stress hormones travel through the bloodstream and trigger a cascade of physical and hormonal reactions.

The interactions between the rapid and slow stress responses are variable, depending on the nature, intensity, and duration of the stressor. One of the most straightforward ways to measure short-term and chronic stress is via levels of the hormone cortisol, which can be sampled in saliva (cheek swabs) or blood (vein draws). Cortisol levels naturally vary throughout the day, rising in the morning from 4 A.M. to a daily peak 30 to 45 minutes after awakening. One’s cortisol level then slowly declines until a smaller late afternoon peak, and later begins a precipitous drop at 10 P.M. until the 4 A.M. trough.

Beyond daily variations, cortisol levels are also raised by threat perceptions. There are anatomical connections among the amygdala (the brain’s urgent fear center), the hippocampus (the memory center), and the hypothalamus (the HPA axis control center), which facilitate cortisol release when a threat is recognized.

BIOLOGICAL EFFECTS OF STRESS

The biological effects of stress are many. Atrophy of the hippocampus, due to severe stress, results in poor concentration, short-term memory loss, increasing impulsivity, and difficulty delaying rewards (time discounting). Chronic stress impairs immune system functioning and increases susceptibility to viral and bacterial infections. ¹¹^, ¹² Weight gain and high blood pressure can result from chronically elevated stress hormones.

Behaviorally, passivity follows from stressful experiences. High cortisol levels in monkeys undergoing stress are correlated with conflict avoidance and decreased aggression.¹³ There are also indications that lower social rank leads to chronic stress and flattened cortisol levels.

Stress, especially uncontrollable stress, elevates levels of a brain enzyme called protein kinase C (PKC). PKC affects parts of the brain involved in abstract reasoning, concentration, and short-term memory. High PKC levels impair short-term memory, concentration, focus, and judgment. Additionally, high levels of PKC increase impulsivity and susceptibility to thought disorders (such as delusions).¹⁴

According to one stress expert, stress is most damaging when one feels a loss of control: “It doesn’t have to be traumatic, as long as you feel out of control,” she said. “Control is the essential factor.... If you are confident, you don’t have these problems.”¹⁵ Unfortunately for investors, control is exactly the thing they lack over the markets. Therefore, to manage investment stress, control must be exerted where it will have an effect, such as in designing bulletproof money management systems, performing superior research, establishing a solid investment philosophy, and communication with clients.

ADRENALINE JUNKIES

If only it were so simple as “stress = bad” and “cortisol = bad.” Yet “adrenaline junkies” and “roller-coaster riders” enjoy recreational stress. There is a paradox here. For most people, moderate stress, over a short period, feels good. Successfully coping with moderate stress can have beneficial physical and emotional effects.

In the brain, moderate amounts of cortisol facilitate dopamine release in the reward pathways. The essence of enjoyable stress is the knowledge that it is taking place in a safe and benign environment, is under control (someone can stop the ride if a malfunction occurs), is somewhat unpredictable, contains surprises, and occurs over short periods—seconds in the case of slot machines, and minutes in the case of a roller coaster.

Most investors enjoy the rush of trading. They like taking risk and savoring the thrills of the market roller coaster. A number of financial planners recommend setting aside a small percentage of one’s total capital for recreational trading. This allows retail investors to get a thrill using a small portion of their total assets without jeopardizing their long-term financial security.

MANAGING INVESTMENT STRESS

In general, if a stressful event is predictable, then it evokes a decreased stress response. The markets are anything but predictable, leading to greater stress among investors who are trying to forecast future price movements. If one becomes acclimated to a stress trigger (such as the fear of heights for an experienced parachutist), then the stress response diminishes to almost nil. Experienced traders do in fact have decreased stress responses to market volatility, but not improved performance.¹⁶

Some financial information predisposes investors to stress. The way that price and order information is displayed taxes cognitive resources. Traders who watch price quotes, tick by tick, are particularly susceptible to chronic stress and burnout. The more one checks stock quotes, the more likely they are to see volatility. When the brain weighs every downtick twice as heavily as every uptick (as described in Chapter 14), the brain undergoes a slow stress erosion. To prevent stress when observing market prices, avoid watching current positions unless they hit a predetermined alarm level (most brokers offer such alarms). Additionally, it can be very helpful to reduce ambient noise. Pressures to multitask during the workday, unless you find those distractions useful for macro pattern recognition, should be minimized.

Many traders can tell a woeful story about the time they shifted their attention during the trading day, maybe to an urgent phone call from a family member, and when they returned to the markets they had lost a huge sum. It’s crucial to minimize distractions during the workday.

Stress is increased by such a lack of control and a perception of conditions worsening. Researchers found that dogs who were given electric shocks that they could terminate by making body motions got fewer ulcers than “yoked” dogs who were given identical but uncontrollable sequences of shocks. ¹⁷ Our perceived ability to exert some control over a noxious event reduces the amount of anxiety and distress we experience.

Many investors operate in isolation from others, acquiring information via impersonal computer monitors or telephone calls with strangers. Social support diminishes the stress response, but many investors have little intimate contact with their families, friends, and even colleagues. Attendance at professional social groups, such as the Technical Security Analysts Association, can be very helpful for finding social support from others dealing with the same challenges in the markets.

Many great investors report that constant information monitoring, while isolating them from their family, helps them to identify developing opportunities before others. Yet, in order to spend more quality time with family or friends, it’s helpful to set strict boundaries on the information that one will monitor after hours.

Investors need to be prepared for every contingency. As positions deteriorate and stress levels rise, the brain becomes cognitively inflexible and unable to think of solutions. Suddenly, panicking out of bleeding positions may appear the only viable option.

SUMMARY

Stress affects every market participant, often in very different ways. Financial advisers working with difficult clients and proprietary traders in volatile markets have very different stressors, but their bodies’ responses are the same.

Investors making high-stakes transactions are susceptible to “choking.” As seen in Ariely’s Indian study in this chapter, choking caused two-thirds fewer subjects to exhibit “very good” performance when they were playing for the highest payoffs. The choking was caused by a performance-deteriorating shift from “automatic” to “manual” control of decision making and behavior. The effects of stress were entirely cognitive, as motor accuracy and speed actually increased in stressed subjects.

Short-term stress triggers hypervigilance, physical preparedness for action, and attention shifting. Acute stress leaves an “action-potential” residue that lingers until it is discharged. Many people develop stress-related disorders because they chronically do not discharge their stress-primed action tendencies. This may be one reason why exercise is so beneficial for health—it discharges the physical action potential.

Chronic stress shrinks the hippocampus and impairs memory, learning, mood, and sleep cycles. Additionally, the chronically stressed have lowered immunity and increased susceptibility to chronic illnesses.

Moderate stress triggers dopamine release in the reward system and promotes learning and development. However, stressors that are unpredictable, uncontrollable, or of worsening severity provoke a more negative stress reaction.

Professionals who experience overwhelming stress may “throw a maiden in the volcano” (sell part of a stressful position) to relieve some of the stress intensity and regain their automatic, intuitive decision-making capacity. Social networks, exercise, and self-discipline in money management are essential to stress reduction.

The next chapter is a cautionary tale of the tragic consequences of gambling in the financial markets.