28th
The Emotion Economy (Part I)
Over the past 18 months, our economy has undergone a violent shift that has changed the lives of many. Our consumer economic and financial models are mostly broken. Political events to corporate bankruptcies can have a huge impact on how we perceive the future. We are at the mercy of an emotional economy.
Utility is the ultimate cause of the economic crisis. I don’t mean utility in the classical sense of the word. Classical economists assume rationality in an attempt to quantify utility. However, people aren’t rational. Households are not good at accurately forecasting the future. We need new economic terms that can account for emotions. Let’s redefine utility to be synonymous with self-interest because that is what truly drives our consumption mix.
Our current economic climate is the result of a perfect storm. Utility theory states that people will maximize their utility at all times. According to the classical definition of utility, we are satisfied with our current mix of consumption at all times. If someone is able to get a mortgage for a house they can’t afford—utility theory says they won’t add that to their mix because that’s not rational. However, if it makes them happier, you better believe they are going to buy that house.
Let’s not forget that bankers are people too. Like Mainstreet, Wallstreet was also maximizing their utility. Banks make money. If you are a bank employee and you are not helping your company generate revenue, you will be replaced by someone who will. Banks maximize shareholder value as all companies should. Earning a living is an important driver of our new utility equation. Many people are probably satisfied earning $250,000/yr, but they might be happier making several million because their purchasing power increases. Everyone’s utility function is different.
Low interest rates and a bank’s propensity to generate revenue led to excessive lending. People were able to get large lines of credit and buy unaffordable homes. What’s worse; mortgages were lumped into CMOs, which helped banks (and bankers) earn more money. I firmly believe that no one really knew, or could have known, the implications of creating these new “investment vehicles.” I am using quotation marks because we now know that they aren’t investments. A large portion of the financial services industry has been based upon selling risk as a means to returns.
I really want to highlight the fact that this crisis can happen again, albeit in a different form. I am pretty sure that we now know enough about CDOs, CMOs, etc, and that they will not cause the next economic crisis. In order to understand why the next crisis will occur, we need to understand how emotions impede our ability to learn in the short run.
If you work in an industry where a significant portion of your net worth or compensation is tied to your results, you are probably familiar with the concept of emotional variance. As your results fluctuate, so do your emotions.
Experience does not make one immune from emotional swings. An experienced trader or serial entrepreneur will still feel the ups and downs, however, they will have become more aware of this concept. In fact, many people jump into an emotionally variant environment without fully understanding its implications.
Let’s take a quick look at the Four Stages of Competence:
1. Unconscious incompetence: The individual neither understands or knows how to do something, nor recognizes the deficit or has a desire to address it. See also : Dunning-Kruger effect
2. Conscious incompetence: Though the individual does not understand or know how to do something, he or she does recognize the deficit, without yet addressing it.
3. Conscious competence: The individual understands or knows how to do something. However, demonstrating the skill or knowledge requires a great deal of consciousness or concentration.
4. Unconscious competence: The individual has had so much practice with a skill that it becomes “second nature” and can be performed easily (often without concentrating too deeply). He or she may or may not be able teach it to others, depending upon how and when it was learned.
Consider the following scenario. A bank hires a junior trader to manage a $10m book. To further simplify, assume that this trader only uses technical analysis in his decision making process (for this example, a chart pattern). After looking at a chart, the trader takes a long position. Even if the chart was correctly analyzed, the trade could move against him. After all, trading comes down to probabilities. Because the trader’s job ultimately depends on his results, he has to make up the losses. It is possible that he could see the same pattern several times, take the correct action, and still have the security move in the wrong direction. If this is the case, the next time (and all other times) he sees that pattern, he may ignore it or take the wrong side. Consciously taking a strategy several times can cause you to take that strategy unconsciously.
The golden rule in trading is to take the emotion out of the trade. In practice, it can be extremely difficult to separate results from your judgment on what is correct and incorrect. It is this reason that markets aren’t efficient. Emotions drive decisions; think fear and greed.
Ultimately, learning in the short run comes down to luck. A trader taking the same exact strategy as the one in our example might have better results. This would cause him to become unconsciously competent in respect to the proper technique.
Some of you may cry foul. You might argue that proper training can give someone the knowledge that they need to succeed. At some level—that’s bullshit. Training can’t simulate emotions. Training can only make you consciously competent. Only in practice can you reach the unconscious competence stage.
I have a theory that states that all successful traders got lucky early in their careers. That is, their positions worked out in their favor when they began trading. Some of these traders were lucky enough to learn as they went, and others were simply in the right place at the right time. It really doesn’t matter—they made money. This is similar to Taleb’s theory in his book Fooled By Randomness. He attributes extreme wealth to luck. I agree that it takes luck to make “fuck you” money—but he is really missing the bigger picture. Taleb contrasts a rich, dumb trader to an intelligent, skilled, underpaid trader. The underpaid trader is equally as lucky (if not more) as the rich, dumb trader.
Getting lucky at the beginning of one’s career and being a successful trader are two very different things. If a trader is only lucky, eventually their results will revert back to the mean. Over time, they will give back all of their gains and the principle, which happened to the rich, dumb trader.
Mistaking luck for skill is dangerous. I think this is particularly relevant to those who start out at large banks because the risk/reward profile is very different. At a large bank, a more experienced trader can have an unlimited tolerance for risk because the losses will weigh on the shareholders (maybe I have heard too many doubling down stories).
If I am trading a security, there are very few things that I can actually control, and for simplicity let’s assume that I am not manipulating a market:
1. The particular security I trade
2. My emotional state at the time of the trade
3. The amount of time I am long/short
A long run profitable (losing) trader will have a positive (negative) statistical expectancy. The formula for statistical expectancy is:
E= [P(w)*S(w)]-[P(l)*S(l)]
P(w) is the chance of a profitable trade. To calculate this you count the number of profitable trades you’ve made and divide that my the total number of trades
S(w)I s the average profit for the profitable trades
P(l) is the chance of a losing trade and is equal to 1-P(w)
S(l) is the average loss of the losing trades
Basically, this is the average profit per trade. If I am averaging $100/trade and make 100 trades, I expect to make $10,000. If I make more, I am running above expectation. Conversely, if I make less, I am running below expectation. In the short run, I think people are too concerned about their results relative to their benchmark. I can run above expectation, make more than $10,000 but still be underperforming my benchmark for a given period of time. As long as my expected profit (in % terms relative to my entire portfolio) exceeds the expected gains of the benchmark, I will beat the benchmark in the long run.
Now, trading is measurable so there are ways to reduce emotional variance and portfolio variance. You can select securities that have a negative covariance (depends on your time horizon). You can prevent yourself from trading when you aren’t in your ideal emotional state. The latter is paramount if you intend on honoring your stops.
I hold this belief that given a situation, everyone is predisposed to react in a specific way. Given all of the information available, I can’t all of a sudden choose a strategy that I don’t know is a good strategy. Alternatively, if I meet a situation where I would normally make a mistake—I can’t decide not to because I am already unconsciously competent. These good and bad strategies are already baked into my statistical expectancy.
I do believe that over time you can break bad habits and relearn proper reactions to different situations. But you need to be conscious of the learning model at the beginning of this post. Relearning involves repeating steps 2-4.
I’ve always been told that there are a lot of mediocre people in finance. I used to think that unskilled people simply found themselves in the right place at the right time. The more I thought about it, the more improbable that seems. How can you always find yourself in the right place at the right time? I’d like to offer an explanation. If you have relied on luck at the beginning of your career, it is highly likely that you have honed and continually relied on other senses. I’m referring to a “gut” feeling. That might sound far-fetched but I bet it stacks up pretty well against skilled traders. Of course, the best of the best will have the proper balance between skills and a gut feeling.
I believe that you need to be lucky to learn in every emotionally variant environment. Although I used trading to illustrate this concept, it applies broadly. Perhaps this is the reason why some startup CEOs can’t properly transition from early stage to late stage. Maybe, they just weren’t lucky enough to learn the proper skills as they went along. On the other hand, maybe some serial entrepreneurs were lucky enough to learn the right way the first time around. Examples of this are countless. But I digress.
I believe we’re all encountering experiences similar to that of a trader. We live in a highly emotionally variant environment. I’m hard pressed to find someone that hasn’t been affected by the economic crisis. All homeowners are aware that they have lost a significant portion of their net worth and anyone who has money in the stock market knows that it’s a casino.
The emotions that one feels when there are violent swings in net worth generally cause highly irrational behavior. If you aren’t used to such an erratic environment, words cannot describe what you feel. It is very deep. However, there are people who have overcome these emotions and can almost act independently of their emotions. I believe that I fall into this group. I’ve experienced a lifetime of emotional variance in just a few short years. I’m a math guy and I’ve always been aware of my statistical expectancy as well as the irrationality my emotions cause. I’m at the point where I can almost act independently of my feelings. This has come at a huge cost. Along the way, I think I lost concept of the value of money, to some degree. I don’t look at financial losses and cringe like many people do. It has just been numbers going up and down in my investment accounts.
The emotions that we feel in this environment are either devastating or numbing—there is no real good outcome. I see evidence everywhere. Many decisions regarding bailouts and stimulus packages are the result of irrationality [I’m not going to say which ones because this is not a political post and you can read about that elsewhere]. I also worry about the emotionally detached group [hello me]. What effects will our cautious lag have? Only time will tell which calls were the right ones. The wrong ones will lay the foundation for the next crisis.
If our emotions impede learning in the short run, and we are constantly maximizing our utility, who’s to say that we won’t face a comparable crisis in the future? How do we know if we have just created a ticking time bomb similar to the mortgage crisis? Hindsight is always 20/20, but it is clear that we do not always understand the immediate consequences of our actions. We can try and take preventative steps, forecast the future, but one thing is certain: the wrong actions will meet the right situation. There will be another perfect storm.
Thanks to Aziz Grieser, Terence McAndrew, Phil Pearlman, Jon Shahrabani, and Justin Stroud for reading drafts of this essay.
