A stock's price is ticking up and down on a screen in front of you. Do you rationally evaluate the probabilities that the price will rise before you pull the trigger on a trade? Or do you go with your gut?
You may prefer to think superior ability—that mysterious X-factor some traders appear to have—is rooted in the former scenario. But a few years ago, researchers at the California Institute of Technology went to the trouble of taking pictures of people’s brains while they were evaluating trades. Surprise: As rational as you are, you probably opt for that gut feeling a lot.
Using fMRI scans, neuroscientists can identify which brain structures are associated with particular activities. To do so, they might put a subject in a machine and have him solve a math problem so they can watch the fireworks go off. Those math-related structures aren’t what lit up in the Caltech experiment. Instead, the activation occurred in parts of the brain associated with something psychologists call “theory of mind.”
That’s essentially the ability to read other people. “It’s a viewpoint on what another person is thinking and feeling and what they’re likely to do,” says Denise Shull, founder of the ReThink Group, a New York research and consulting firm that coaches financial professionals and athletes. You unconsciously use theory of mind all the time to process experiences in the world, says Shull. It’s what helps you navigate a busy Manhattan sidewalk: You can tell that the guy in front of you is about to veer to the right, so you step to the left. It’s also what enables some traders to look at the tape, she says, and see that “someone’s slamming the bid.”
In the Caltech experiment, detailed in “Exploring the Nature of ‘Trader Intuition,’ ” a paper published in the Journal of Finance in 2010, researchers set up a stylized market. They had participants trade two “stocks” in a series of sessions. The payoff from the two stocks together was fixed at 50¢, but the portion of the payout that would come from each stock was revealed only after the session ended. One might pay 49¢ and the other would pay 1¢, for example.
In some of the sessions, none of the participants had any additional information about the payoffs. In other sessions, some participants were given a hint about what the payoffs would be. Based on that hint, those participants might bid up one of the stocks.
The trading during those sessions took place electronically and was videotaped. Later, a different group of subjects watched replays. After a while, a researcher would stop the video and ask the subjects to predict what the next price would be.
In the sessions where some traders were acting on hints about the payoff, the observers could infer information about how stocks would move just from watching the prices and flow of orders. The explanation: The fMRI scans showed the observers had engaged the theory-of-mind-related parts of their brains. Also, the observers who were better at predicting prices did better on separate tests of theory-of-mind abilities.
The Caltech study has some interesting implications. Among them: Theory of mind may explain how uninformed traders infer new information and act on it in such a way that prices quickly come to fully reflect it—as is posited by the efficient markets hypothesis, a cornerstone of finance theory.
Peter Bossaerts, an author of the Caltech study who’s now a professor of experimental finance and decision neuroscience at the University of Melbourne, says subsequent research also supports the idea that theory of mind may explain how information flows through markets. “We have more evidence for it,” he said in an e-mail, citing papers that show connections between theory of mind and market bubbles.
The mysterious X-factor isn’t such a mystery after all, according to ReThink’s Shull. “I would describe the X-factor of risk judgment as part of a suite of emotional competencies that extends from knowledge to recognition to understanding,” she says. One part is emotional self-awareness—knowing not to make a decision when you’re agitated, for example. Another is the ability to predict prices and read people.
So, can you sharpen your skills for that? Yes, says Shull. “It’s trainable.” Although theory of mind is unconscious, Shull says there’s a conscious version of the same type of processing, which she calls cognitive empathy. “Cognitive empathy is thinking about it and trying to do it intentionally, and that’s where you can train yourself,” she says. The new Bloomberg Tradebook Trader Exercise lets you test your abilities and practice to improve them. Developed by Shull’s ReThink Group in conjunction with Tradebook, Bloomberg’s agency brokerage, the activity uses various animated shapes to challenge your gray matter. Keep an eye on that pentagon!
Asmundsson is <GO> editor of Bloomberg Markets.