Sunday, May 06, 2007

Is Trading Style Hard-Wired?

Perhaps the most common assumption made by traders and trading psychologists alike is that people are capable of adapting to any market or trading methodology.

An increasing body of knowledge, however, suggests that many of the personality factors that affect decision-making under conditions of risk and uncertainty are hard-wired. Brain scans, for instance, predict who will be risk takers in gambling situations and who will be risk-averse. As one researcher bluntly puts it, "Brain activity predicts behavior."

A key element in decision-making is the brain's reactivity to loss vs. gain in decision-making. When the brain responds much more to loss than gain, individuals are far more likely to be averse to gambling. When the brain's "reward centers" respond to winning about as much as losing, the result is risk-seeking behavior. Interestingly, the brain areas that respond to winning money are the same as those that respond to cocaine or chocolate. This helps to account for the frequency of addictive behavior among gamblers--and traders.

Such individuals are not only risk-seeking, but stimulation-seeking. They have a low tolerance for boredom and use risky behavior to generate interest in their environment. Research suggests that easily bored individuals are more prone to depression and addiction than other people. Easily bored people also tend to have lower attention spans than others, increasing the odds of impulsive behavior. Such individuals would have particular difficulty adhering to trading plans and discipline.

Different brain mechanisms have been found to mediate risk-taking and risk-aversion in financial situations. A particularly interesting finding is that the dopamine reward center kicks in about two seconds prior to making a risky decision. Conversely, a brain center that is responsible for emotions of anxiety and repulsion is activated prior to suboptimal, risk-averse decisions.

We have no problem with the notion that some individuals are born with physiques that enable them to be successful in athletic contests. It is more controversial, however, to assert that some of us may be born with greater ability to make rational financial decisions than others. And there may be people with brain processes and psychological makeups who should avoid trading as assiduously as they might avoid cocaine.

It's nice to think that any trader can trade any market or methodology. The reality, however, is that we seem to be hard-wired to prefer certain levels of risk and stimulation. It may be more effective to fit trading methods to individuals than to hope to overcome hard wiring and teach a particular style to all traders.