Today marks the kick-off edition of Mind Over Money, the only podcast that exposes the psychology of investing. I’m Kevin Cook, your field-guide and story-teller for the fascinating arena known as behavioral economics, which includes the sub-field behavioral finance and also draws in the related research from neuroscience, where brain imaging “sheds light,” if you’ll pardon the pun, on how we make decisions about money, uncertainty, and risk.
Jason Zweig described these merging fields in his 2007 book Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich.
Zweig, as you may know, wrote for Money magazine for years and was the editor of the revised edition of Benjamin Graham’s The Intelligent Investor. He now writes for the WSJ. So he wasn’t just a journalist describing an investing fad. He’s schooled in classical investing methods and knew he was on to something of enduring importance when he either coined, or at least put on the map, the term “neuroeconomics.”
He opens his book, which I consider must-reading for all students of the market, this way…
“How could I have been such an idiot?” If you’ve never yelled that sentence at yourself in a fury, you’re not an investor. There may be nothing across the entire spectrum of human endeavor that makes so many smart people feel so stupid as investing does.
But actually, I didn’t discover Jason’s book until about 5 years ago. And I had been working on the same ideas as him prior to the financial crisis. In fact, I published part of my thesis that “Your Brain Wasn’t Made to Trade” in 2008 in an industry magazine called SFO, which stood for Stocks, Futures, and Options.
My objective with Mind Over Money is to inspire you to be nearly as interested in behavioral economics, behavioral finance, and neuroscience as Mr. Zweig and I both are. And of course, we both give you plenty of other experts and resources to aid in that endeavor. That’s because so many great and dedicated researchers came before us and created the invaluable insights of these fields.
My unique contribution is that before I discovered behavioral finance or became passionately interested in brain science, I was studying great traders and terrible traders, through their successes and their failures, on the trading floors of Chicago since the mid-1990s.
This Is Your Brain on Risk
There are a lot of forces and players on Wall Street that can separate you from your money. But our greatest financial enemy is often ourselves.
Three great areas of study give us insight about this self-sabotage: behavioral finance, neuroscience, and the collective wisdom of great investors and traders who discovered through hard-won experience what those two sciences now teach us.
When we study these areas, we can become more aware and better equipped to spot how our own minds and habits either get in the way or help us make better decisions when it comes to money, uncertainty, and risk.
One group of researchers studies people from the outside-in, the behavioral finance group, who owe much to the ground-breaking work of Daniel Kahneman and Amos Tversky in the 1970s.
The other group, the neuroscientists, studies our behavior from the inside-out, as they pinpoint what brain structures and functions are involved in different types of decisions and responses.
What happens when our minds meet markets has been a passionate area of interest for me for over 20 years, ever since I first walked on the trading floors of Chicago and watched the good, the bad, and the ugly among professional speculators.
So how did I come to the conclusion that “your brain wasn’t made to trade?” It’s a bold statement. But once I show you the evidence behind it, I bet you will agree.
The Era of Rogues and Geniuses
In 1995, when my trading career was first getting started, the oldest bank in the world collapsed because of the rogue actions of one employee. Founded in 1762, Barings Bank was wiped out by trader Nick Leeson who was taking on exceptionally large trades – and losses – in Japan’s Nikkei futures market.
And he was able to hide them for a time until the risk managers finally woke up and started to notice that accounts were not balancing.
At the time, it seemed people everywhere – from journalists and regulators to traders, bankers, and the man or woman on the street – were all shocked that something like this could happen.
I started tracking stories like this, especially as they seemed to be occurring more often. In 1998, we saw the biggest hedge fund failure ever – up to that time. It is dwarfed by comparison since then.
Long-Term Capital Management had to be bailed out by 16 Wall Street investment banks, in a campaign orchestrated by the Greenspan-led Federal Reserve, because their losses in interest rate sensitive markets around the globe were viewed as threatening to financial markets.
The bailout at over $3.5 billion is considered paltry by today’s “too big to fail” standards. But the truly notable dynamic was that the fund was run by some of the smartest minds on Wall Street, like Myron Scholes who had just won a Nobel prize in Economics the year before.
I also kept track of the big blow-outs I witnessed in the trading pits in Chicago. New floor traders would always come and go on a regular basis. But the surprises came when a 20-year veteran would suddenly vanish because he took exceptional risk that went way wrong and wiped out a multi-million dollar account.
Rogues, Gamblers, and Wizards: What can we learn from them?
As I watched the rogues and the blowouts, I also read about the great traders. Jack Schwager’s books about the Market Wizards are really required reading for anyone who wants to become a full-time trader. They are in-depth interviews with big successes like George Soros, Paul Tudor Jones, Michael Steinhardt, and options wizards like Blair Hull.
As I read these dozens of interviews across 3 of Schwager’s books, I found six themes all these great traders and investors had in common. I’m going to list them for you because even before I had ever heard of behavioral finance or became interested in brain science, these “street-smart” winners had cornered the market on the principles of being in command of their own minds and trading behavior:
1. Psychology: emotional decision-making was a paramount discovery
2. Discipline: having lost big without them, rules became lifesavers
3. Risk Management: the “golden rule” is to cut losses quickly and let winners run
4. Probability: repeatable methods & mechanics of risk/reward evaluation
5. Consistency: steady compounding was better than windfalls and wipeouts
6. Systems: putting the first 5 together in routines of planning & preparation
When I became a professional currency trader in 1999 upon the introduction of the euro, I noticed that even bank traders were an emotional and irrational bunch. As I studied the two sciences, I concluded that our brains were “hard-wired” to break the “golden rule” of trading.
In other words, our fear-driven, excitable, and emotional brains preferred (1) to avoid losses at all costs (so we would only take them when it was almost too late) and (2) to take gains quickly. This irrational and upside-down approach to risk/ and reward was the mathematical road to insolvency.
So I started researching how to train “trader brains” and I developed a probability simulation called Masters of PROP: Probability, Risk, and Optimal Profit. That trader training never goes out of date because its subject material, human brains, remain irrational, decade after decade.
Is It All Just About Greed?
So if the Market Wizards principles of the world’s best traders and investors worked so universally, what were the rogue traders and reckless fund managers doing – just the opposite?
Well, it’s a little more complicated than that. Because while there might be a half-dozen ways to do things right, there are many dozens, if not hundreds, of ways to make our money go away.
What always gets highlighted with rogues and “geniuses” that fail is that they were just greedy. But as I put together my thesis that “Your Brain Wasn’t Made to Trade” in the early 2000s, I came up with 3 more distinct and important drivers of financial bad behavior…
#1: Ego and the desire to be seen as “the great trader.” This was evident in so many of the rogue trader stories, like John Rusnak accumulating $700 million in losses for Allied Irish bank between 1997 and 2002.
#2: Irrational or immature beliefs about money, success, self-worth, and happiness such as “I deserve it!” or “This needs to happen now!” or “Once I win this back, I’ll make everything right again.” This kind of stuff tends toward either unconscious or full-blown narcissism with lots of emotional immaturity in between.
#3: Ignorance or lack of skill with probability
The primary reason I think we gain so much from studying rogues and other reckless gamblers is because what the rogue does to a billion dollars of other people’s money, we can do to our own accounts if we are not aware of our mental habits and cognitive biases as they impact our decision-making with money and risk.
And here, I have a confession to make.
While I could be as guilty as any investor-trader of any of these faults, the one I knew I had to immediately do something about was Probability. As a trading floor clerk in the late 1990s, I realized I had to make up for my lack of understanding and skill with probability.
And since equations were not my favorite things in high school or college, I found that the stories of how probability was invented and how it was used – in the options markets, in Vegas, in sports, and in weather modeling – pulled me in and gave me a practical way to learn the math I needed to know.
I must have read the stories of how Pascal and Fermat invented modern probability theory in the 1650s a dozen times before it started to sink in and I could make sense of all the equations that came after.
But you’re probably still wondering where I get the nerve to say Your Brain Wasn’t Made to Trade?
It’s all in this week’s podcast.
And be sure to check out my weekly video where I expose the psychology of investing with behavioral and cognitive biases. My most recent gives a great example of mental accounting.