Monday, November 06, 2006

The Most Promising Application of Psychology to Trading

If trading firms managed money as scientifically as they conduct their hiring, most would be out of business quickly.

The problem is prevalent in the business world. We have sophisticated tools for accounting, process control, and marketing, but hiring practices remain mired in the subjectivity of personal interviews and reviews of resumes.

Hiring new traders poses special challenges. Without an established track record of success, how can firms determine if candidates have the skills and talents needed to succeed?

Few people are aware that research in psychology has led to the creation of highly realistic simulations that allow firms to directly measure the competencies needed for success. The studies of Drs. Siegfried Streufert and Usha Satish are particularly noteworthy in this regard. Their Strategic Management Simulations put candidates through a series of scenarios that require decision making. The decisions made and rationales for these are used to create a web-like diagram of the candidate's cognitive functioning. What the diagram actually measures, the researchers note, are aspects of frontal activity in the brain.

The brain's frontal cortex is called by cognitive neuroscientist Elkhonon Goldberg our executive center. It is responsible for much of our reasoning, planning, judgment, analysis, and problem-solving. By creating standardized tasks for a variety of professions--from CEOs to physicians--Streufert and Satish in essence have designed a methodology to match people's brains to the work they will be doing.

The implications for trading are immense.

It is not difficult to create highly realistic trading simulations utilizing actual historical market data. By asking traders to trade a standardized set of markets and track news and market events as they occur, we can analyze their reasons for decisions. This analysis will generate cognitive maps that display how candidate traders think and behave under varying conditions of challenge, complexity, and stress. We can directly observe how people handle risk, how their emotions aid or hinder their objectivity, and how they manage change and new information.

If simulations on a computer can accurately predict the performance of surgeons, perhaps they can unlock some of the factors that account for trading success. Perhaps, too, they can help identify future superstar performers.

The most promising application of psychology to trading--and many other fields--comes, not from the therapy couch, but from cognitive neuroscience. Quietly, in a variety of fields, matching brains to tasks is revolutionizing hiring practice.