The Difference Between A Good And A Bad Trader: What Brain Imaging Reveals

Tyler Durden's picture

The age old question: what is the difference between a good trader and a bad trader... aside from the P&L at the end of the day of course.

While luck has always been a major component of the equation, figuring out just what makes one trader successful, while another blows all his funds on a trade gone horribly bad has always been the holy grail of behavioral finance. Because if one can isolate what makes a good trader "ticks, that something can then be bottled, packaged and resold at a massive markup (and thus, another good trade) in the process making everyone the functional equivalent of Warren Buffett.

Or so the myth goes. Alas, the distinction between the world's only two types of traders has been a very vague one.

Until now.

According to a new study by researchers at Caltech and Virginia Tech that looked at the brain activity and behavior of people trading in experimental markets where price bubbles formed, an early warning signal tips off smart traders when to get out even as the "dumb" ones keep ploughing in and chasing the momentum wave. In such markets, where price far outpaces actual value, it appears that wise traders receive an early warning signal from their brains—a warning that makes them feel uncomfortable and urges them to sell, sell, sell.

"Seeing what's going on in people's brains when they are trading suggests that Buffett was right on target," says Colin Camerer, the Robert Kirby Professor of Behavioral Economics at Caltech.   He is referring, of course, to Warren Buffett's suggestion that investors should try to "be fearful when others are greedy and be greedy only when others are fearful."

That is because in their experimental markets, Camerer and his colleagues found two distinct types of activity in the brains of participants—one that made a small fraction of participants nervous and prompted them to sell their experimental shares even as prices were on the rise, and another that was much more common and made traders behave in a greedy way, buying aggressively during the bubble and even after the peak. The lucky few who received the early warning signal got out of the market early, ultimately causing the bubble to burst, and earned the most money. The others displayed what former Federal Reserve chairman Alan Greenspan called "irrational exuberance" and lost their proverbial shirts.

The Experiment

The researchers set up a simple experimental market in which they were able to control the fundamental, or actual, value of a traded risky asset. In each of 16 sessions, about 20 participants were told how an on-screen trading market worked and were given 100 units of experimental currency and six shares of the risky asset. Then, over the course of 50 trading periods, the traders indicated by pressing keyboard buttons whether they wanted to buy, sell, or hold shares at various prices. 

Given the way the experiment was set up, the fundamental price of the risky asset was 14 currency units. Yet in many sessions, the traded price rose well above that—sometimes three to five times as high—creating bubble markets that eventually crashed.

During the experiment, two or three additional subjects per session also participated in the market while having their brains scanned by a functional magnetic resonance imaging (fMRI) machine. In fMRI, blood flow is monitored and used as a proxy for brain activation. If a brain region shows a relatively high level of blood oxygenation during a task, that region is thought to be particularly active.

At the end of the experiment, the researchers first sought to understand the behavioral data—the choices the participants made and the resulting market activity—before analyzing the fMRI scans.

"The first thing we saw was that even in an environment where you don't have squawking heads and all kinds of other information being fed to people, you can get bubbles just through pricing dynamics that occur naturally," says Camerer. This finding is at odds with what some economists have held—that bubbles are rare or are caused by misinformation or hype.

Next, the researchers divided the participants into three categories based on their earnings during their 50 trading periods—low, medium, and high earners. They found that the low earners tended to be momentum buyers who started buying as prices went up and then kept buying even as prices tanked. The middle-of-the-road folks didn't take many risks at all and, as a result, neither made nor lost the most money. And the traders who earned the most bought early and sold when prices were on the rise.

"The high-earning traders are the most interesting people to us," Camerer says. "Emotionally, they have to do something really hard: sell into a rising market. We thought that something must be going on in their brains that gives them an early warning signal."

Perhaps this explains why the Fed's job is so difficult: after all it has to pander to momentum-chasing idiots, the same group of people who always blows up in the end. Ironically, this is perhaps the best reason why the Fed's centrally-planned attempt to intervene in markets and hand off the baton of price discovery to the momo group is doomed to failure.

Irrational Exuberance

To reveal what was actually occurring in the brains of the subjects—and the nature of that warning signal—Camerer and his colleagues analyzed the fMRI scans. Using this data, the researchers first looked for an area of the brain that was unusually active when the results screen came up that told participants their outcome for the last trading period. It turned out that a region called the nucleus accumbens (NAcc) lit up at that time in all participants, showing more activity when shares were bought or sold. The NAcc is associated with reward processing—it lights up when people are given expected rewards such as money or juice or a smile, for example. So it was not particularly surprising to see that the NAcc was activated when traders found out how their gambles paid off.

What was surprising, though, was that low earners were very sensitive to activity in the NAcc: when they experienced the most activity in the NAcc, they bought a lot of the risky asset. "That is a correlation we can call irrational exuberance," Camerer says. "Exuberance is the brain signal, and the irrational part is buying so many shares. The people who make the most money have low sensitivity to the same brain signal. Even though they're having the same mental reaction, they're not translating it into buying as aggressively."

Returning to the question of the high earners and their early warning signal, the researchers hypothesized that a part of the brain called the insular cortex, or insula, might be serving as that bellwether. The insula was a good candidate because previous studies had linked it to financial uncertainty and risk aversion. It is also known to reflect negative emotions associated with bodily sensations such as being shocked or smelling something disgusting, or even with feelings of social discomfort like those that come with being treated unfairly or being excluded.

Looking at the brain data of the high earners, the researchers found that insula activity did indeed increase shortly before the traders switched from buying to selling. And again, Camerer notes, "The prices were still going up at that time, so they couldn't be making pessimistic predictions just based on the recent price trend. We think this is a real warning signal."

Meanwhile, in the low earners, insula activity actually decreased, perhaps allowing their irrational exuberance to continue unchecked. 

Read Montague, director of the Human Neuroimaging Laboratory at the Virginia Tech Carilion Research Institute and one of the paper's senior authors, emphasizes the importance of group dynamics, or group thinking, in the study. "Individual human brains are indeed powerful alone, but in groups we know they can build bridges, spacecraft, microscopes, and even economic systems," he says. "This is one of the next frontiers in neuroscience—understanding the social mind."

Conclusion

Clearly more work needs to be done, but what emerges is that momentum based strategies, those that by definition perpetuate bubbles, are the the most rewarding in the short run and the most disastrous in the long run. Ironically, in the artificial "BTFD" market created by the Federal Reserve, the only strategy that still works (aside from going long the most shorted names) is riding the momentum wave (whether it is facilitated by the Fed's balance sheet or not). The problem is that momentum be definition sows the seeds of its own destruction. Perhaps this also explains why some of the most prestigious and acclaimed investors of more than one generation, those who "sold" as the market went higher, higher, higher and is now at post-bubble valuation levels, have abandoned the market entirely, leaving it to the momos and the Fed to keep perpetuating the lie that this time the bubble won't burst.

And maybe the Caltech study should have been rerun in the Fed's bizarro world: a place where only momentum strategies are rewarded - at least for now - while those who in theory would be "high earners" are mocked and ridiculed by the momo brigade whose only skillset is just to push the green button.

Who knows, maybe the lunatics have indeed taken over the asylum and this time indeed will be different.

And to think: the Fed has only engaged in QE for "ony" 5 out of its illustrious 100 year history. Consider the "wealth effect" Bernanke, Yellen and company left on the table by not launching QE back in 1913. Surely everyone would be a trillionaire by now and the world would be overflowing in "wealth"...

Source: "Irrational exuberance and neural warning signals during endogenous experimental market bubbles"