On the other hand, we have been strikingly irrational in not noticing one thing about ourselves.
In much of economics and psychology, we have been looking for the answers in only two of the three dimensions of the human mind and psyche—thought and behavior. This approach leaves a logical (or rational) gap no matter which way you prefer your metacognition! Clearly thinking and doing includes a third dimension—the much messier realm of how we feel when we are thinking or “behaving.”
We “kinda-sorta” give credence to it in an abstract way. CNBC of late has cried out for animal spirits. We gauge sentiment with monthly research reports. We, or at least portfolio managers and traders at major banks, talk about confidence and conviction. But in the Ivory Towers where people who spend all of their time thinking about models of decisions, the focus remains mostly, although luckily not exclusively, on expected utility and emotion regulation, i.e., perceived value and emotion reduction. The assumptions about the superiority of our cognitive capacities are just that—assumptions.
Assembling data from multiple fields of neuroscience, however, demands that we realize we are more than our thoughts and our behaviors. We are in fact, mostly feeling beings.
The tenets of the cognitive “revolution”—triune models of the brain, neural doctrines, two different brain systems, a logical and an emotional one, are about to be faced with extinction.
For example, two weeks ago, we discussed the “it” factor in IBM’s “Watson.” Anyone care to remember what it was? “Confidence?” said Renee from her intentionally chosen seat one away from Michael.
Exactly!
And where in your being does confidence occur? Literally—is it a thought or a feeling? Is it a sense or an experience in your skull?
Watson, the Jeopardy-playing computer simulated full humanity, or what we feel via calculation. Yes, it is another technological feat for Watson to comprehend natural language the way that “he” does. But the point here is how much like a human he had to become to do it. Essentially, Watson needed to know what he believed and to make a judgment call based on an electronic form of the feeling of confidence. He won—yes. But if you really look at it, he did so because he could “know” that he “felt” confident much more quickly than his human competitors.
As it turns out, the historical schools of rationalism and empiricism both missed out on something that the philosopher Hume noticed, Darwin wrote about, Freud expanded upon, and now brain scientists are demonstrating. The missing ingredient combines a bit of both—observation that other factors are at work and the logical deduction that these factors may explain a lot, maybe even everything.
David Hume, the 19th-century philosopher, generally considered to be in the empirical camp, noticed it when he said that reason is subject to passion, or we think things are a certain way because we want them to be that way—a comment that almost predicts the now-demonstrated ambiguity aversion. Later, Darwin wrote a book called The Expression of the Emotions in Man and Animals. He described emotions as the source of beneficial actions. Fear and anger could lead a person to behave in a way that saved them from harm. Freud, arguably, combined empiricism and rationalism when he abandoned his Project for a Scientific Psychology—an explication of the neuroanatomy and chemistry of thoughts and feelings—and settled for the backward induction of deducing how people must be feeling from either their behavior or their distressing bodily symptoms.
And now neuroscience—in fact, a whole new world of neuroscience—is catching up. You often hear of the triune model of the brain, which says that the frontal cortex makes us human, the middle of the brain mediates emotion, and the base of the brain keeps your heart beating. The neuroscience vanguard, however, abandoned that concept a few years ago. The newest understanding states that perception occurs from snippets of activity across the brain; or that the brain works more in line with how the glia cells work, as we discussed in our previous lecture.
This new knowledge of the brain logically matches what we are learning about context being crucial to everything from where the brain does math, to how language is interpreted, to assumptions about emotion. It runs parallel to the widely supported idea that “meaning” as identified through emotion, underlies decision making. If you think about it, the concept of the “background” broadcast of the 85% of your brain that is glia logically lines up with the empirical evidence for beliefs governing perception—if you are a quant, you believe in quant, or if you are a technical or fundamental analyst, you believe in your methods. And your beliefs implicitly include the emotion of confidence. Otherwise, you would doubt—and not believe—and look for another method!
In a brain that creates efficiency through the use of context, is not wanting to take another loss (emphasizing more recent experience) actually irrational, or is it conservative? Maybe a loss creates a context of fear, which would not be irrational, and in turn we become more cautious.
The problem stems not from hardwired tendencies to make poor judgment calls but instead from learned or mis-learned ideas about all of the dimensions of our psyches and how they fit together to create the contexts in which we think, analyze, and decide. Maybe we just need to learn to operate the machinery of our minds via a whole new user’s manual.
Antonio Damasio, now widely considered one of the world’s foremost neuroscientists, first brought this to the world’s attention with an argument to counter the rationalists in his 1994 bestseller, Descartes’ Error. He and his colleagues detailed numerous accounts of individuals who had sustained brain damage to areas of the brain known to be particularly important to the experience of emotion. After their injuries, these patients became completely unable to make even the simplest of decisions. One patient simply couldn’t choose between two dates for an appointment, railing on for quite a long time about the benefits and liabilities of two different dates until, finally, Damasio just told him which date to come back. Others couldn’t make a choice about which cereal to buy or what combination of clothing to wear in the morning.
The work contributed to, or re-ignited, two major ideas that had fallen by the wayside through the ages of rational, computer-like thinking about the human brain. One, it reconnected the whole system by noting that we feel emotion primarily in our bodies not in our heads. And second, when we can’t feel, much of who we are or can be disappears. Damasio correctly asserted the famous saying should be: “I feel therefore I am.”
In fact, while unfortunately Wall Street has gone about its business in ignorance of the centrality of emotion, a few more bold scientists, with their eyes wide open, sought to further the discussion about thinking and emotion. And guess what? Every day more research proves that not only are emotions not something to be shunned, dismissed, or overridden, but we need them for meaning, we need them for vision, and we use them for essentially everything. We might be able to resolve an equation without being attached to it, but if we didn’t want the answer for some other reason, why would we?
Therefore, ironically, the last thing you want is no emotion!
We can’t actually apply math or logic, let alone do other analyses, make judgments, or decisions, if we lack feeling and emotion.
If A therefore depends on B, then how can B be inferior to A? Thinking it is, is ironically and exactly illogical!
Neuroeconomics specifically studies the brain-making economic decisions. In 2005, a great article ran in the Journal of Economic Literature. Titled “Neuroeconomics: How Neuroscience Can Inform Economics,” the article’s authors made the point over and over:
“It is not enough to ‘know’ what should be done; it is also necessary to ‘feel’ it” and “to influence behavior, the cognitive system must operate via the affective system.” (Affect being the academic word for emotion).
These two sentences, by the way, ultimately encompass everything you need to know about the psychology of decision making under uncertainty. Think about it—if it is not enough to simply know and a feeling must be had to act, then every act has a feeling substrate, and all you really need to do is know what it is to do more of what you want.
And then, like Markowitz harkening back to his stage one of beliefs, they rephrased their point again: “We are only now beginning to appreciate the importance of affect for normal decision making.”
Having drawn their own four-quadrant model of the mind where the first quadrant is that linear deliberate SAT-acing–type thinking, they also surmise how so many of us might have missed this: “Since quadrant 1 often does not have conscious access to activity in the other quadrants, it is perhaps not surprising that it tends to over-attribute behavior to itself—i.e., to deliberate decision processes.”
But be forewarned.
It gets worse—or better—depending on your vantage point. Those dedicated to the cause of probabilistic rationalism took another hit two years later with an article entitled, “Being Emotional During Decision Making—Good or Bad? An Empirical Investigation.” Underscoring the radical drift of what our aforementioned team deemed “Radical Neuroeconomics,” these scientists stated:
Contrary to the popular belief that feelings are generally bad for decision making, we found that individuals who experienced more intense feelings had higher decision-making performance….
Individuals who were better able to identify and distinguish among their current feelings achieved higher decision-making performance….
This study suggests that whether their feelings are actually beneficial or harmful to decisions may largely depend upon how people experience, treat and use their feelings during decision making.
This is the emotions-as-data school that my company uses as our foundation of improving the performance and decision-making skills of traders, C-suiters, and athletes. But in the meantime, can anyone tell me why with this kind of science now becoming very old news, HSBC still pays for newspaper ads saying, “Never let emotions cloud your judgment” and deeming it “textbook financial advice”?
Michael chuckled. He had to admit he was becoming a convert to this new psychology of uncertainty and couldn’t help but answer, “Well, as their behavior and your logic has explained, banks aren’t exactly spending any time thinking about anything other than formulas now, are they?”
I guess that is the point, isn’t it, Michael? It may be textbook (or otherwise I wouldn’t be here giving this lecture, would I?), but that doesn’t make it good advice. If HSBC or any other broker could literally remove emotions from their clients’ judgments, they would be very sorry. As no decisions would be made at all, no commission revenue would be gained.
Over the course of these past few Friday afternoons, we’ve covered the following points:
Despite our desire, we can never know for sure what will happen tomorrow.
Probabilities tell us something but not everything we would like to, or need to, know.
Deciding how to divide up a pot of cash should be done only after one explicitly knows what they believe and why they believe it.
Even then, at the end of the day, judgment will come into play.
Judgment requires emotion. (Don’t think you aren’t using it.)
So here’s the challenge. Watson the computer may have been able to “enumerate” confidence, but in the reality of human markets and humans making both market and model decisions, that isn’t the way it goes. We might be able to learn to systematically analyze our internal confidence levels and we can certainly change our processes so that we become systematic about the qualitative; but so far, very few people on Wall Street, no matter what their rank, have done it.
On the day of the Flash Crash in May 2010, certain traders used not their models but their brains, their memories, and their pattern recognition skills to immediately decide to shut down their automatic trading systems. They judged something to be awry. They didn’t know what; but in effect, their lack of confidence or what could also be called that dreaded word “fear” served as their best risk manager.
That is exactly how Darwin said it was supposed to work—an emotion like fear could be useful. As it turns out, that famous saying, “The only thing we have to fear is fear itself” is another mistake.
In fact, the only true thing we have to fear, at least when it comes to decision about uncertainty, is a complete lack of fear.
To trade or make any decision under the auspices of uncertainty, one should always explicitly know where they stand on the spectrum of fear to confidence. If they do, they have a shot at knowing their preexisting conditions of beliefs and, in turn, at making their best judgment call. I challenge you, as you leave this lecture, to devise for yourselves the self-awareness and tracking systems that will indeed allow you to do so. If you do, you can be confident that you’ll be honoring the wisdom of the ages as well as the working in concert with your entire suite of mental faculties. Ultimately, this strategy paves the way to to knowing the difference between a plethora of different types of feelings, intuition and impulse, being two that everyone would like to be facile with.
In turn, and most importantly, you will always live to trade another day!