Study Attempts to Pin Down What it Means to Think Like a Trader

See related feature: Anatomy of a Buy Side Trader

The psychology of a trader has long been studied as observers try to understand the mentality of someone whose career is propelled by the highs of making money and often is defined by risk taking. In fact, recent research published in the journal Proceedings of the National Academy of Sciences (PNAS) found that "thinking like a trader" reduces loss aversion.

For the study, student subjects were instructed to make choices about monetary gambles; half the time they were instructed to "think like a trader," relates Colin Camerer, the lead researcher/author on the study and a Robert Kirby Professor of Behavioral Finance and Economics at the California Institute of Technology (Caltech).

The study focused on a phenomenon known as loss aversion. "Dollar for dollar people hate to lose more than they like to win. Loss aversion is for the unit you dislike losing a lot more than you like gaining an equal amount," says Camerer

"We told people to 'Think like a trader, and you're going to win some and lose some but it's not your money,' " he explains. "We were interested in whether that would reduce their fear of loss, and it seemed to work pretty well."

Camerer says the study measured skin conductants and how much palm sweating the subjects experienced when they found out whether they had won or lost on their bets. "They don't sweat the losses when they're in the mode of 'Think like a trader.' There's a biological effect of controlling the emotions in this way," he notes.

The research, Camerer adds, eventually could impact hiring practices. "Knowing something about how brains work, you could hire the right people and train them," he says.

In addition the research could provide insight into trader burnout and the long-term effects of risk taking. "What happens when people are doing something very intense for many years? What happens to their brain is unknown," Camerer says.

"If you have the ability to work in a market where you can win 51 percent of the time, and you do that for years in a trading operation and make a billion dollars -- anyone who can withstand that day-to-day loss is going to get ahead," he adds. "Emotional control is a pretty powerful tool."

But do traders eventually become numb to risk? "The dark side of this is you don't want a person who never cares if the firm loses money; that might be a recipe for rogue trading," cautions Camerer. "You want the capacity to feel fear and appreciate it and not let it overwhelm."

Fear Factor

All of this psychology obviously affects a trader's decision making. "When trading in fast-moving markets, the challenge is to make good decisions fast while under pressure and not mull over and regret mistakes," Camerer points out. "Traders don't have time to Google and ask 20 people what they would do -- they have milliseconds to decide. We don't know much about quality of decisions under extreme time pressure."

Camerer also points to a recent study on the link between testosterone and a trader's ability to take challenging but sensible risks. The University of Cambridge research, which was published in the April 2008 issue of Proceedings of the National Academy of Sciences, found traders' testosterone levels to be higher on days when profits were above the trader's one-month daily average. According to Camerer, the research suggests that elevated testosterone may boost trader confidence and increase risk taking, which ultimately could help trading results.

"When traders in our study experienced acutely raised testosterone, for example, they made higher profits, perhaps because testosterone has been found ... to increase search persistence, appetite for risk and fearlessness in the face of novelty, qualities that would augment the performance of any trader who had a positive expected return," the published research observed.

"However," the research noted, "if testosterone continued to rise or became chronically elevated, it could begin to have the opposite effect on P&L and survival, because testosterone has also been found to lead to impulsivity and sensation seeking, to harmful risk taking."