Measuring the Stress of Financial Traders

"Emotional responses are a significant factor in the real-time processing of financial risks, even among the most rational investors in the economy."

In The Psychophysiology of Real-Time Financial Risk Processing (NBER Working Paper No. 8508), NBER Research Associate Andrew Lo and coauthor Dmitry Repin marry the biomedical and the social sciences by investigating the role that emotion plays in the high-stakes and high-pressure world of professional securities traders, individuals who, by their training and inclination, are presumably among the most rational decisionmakers in the economy.

Proponents of what is alternately called behavioral economics or behavioral finance maintain that investors often are guided by irrational feelings such as overconfidence, overreaction, herd mentality, loss aversion, fear, greed, or simply optimism and pessimism. At the same time, a competing view is that despite the pressures engendered by minute-to-minute transaction opportunities, professional traders function purely on the basis of intellect and rational analysis.

Recent research conducted in both the cognitive sciences and in financial economics suggests that emotions, in fact, play a significant role in the thinking process. Lo and Repin set out to test this notion. They measure and analyze data arising from autonomic nervous system responses of ten professional traders --foreign exchange and interest-rate derivatives traders employed by a major Boston financial institution -- as they make decisions in real time during live trading sessions. The traders fall into two groups: five who are considered highly experienced and five who have low or moderate experience.

Each trader was "wired" with six electronic sensors attached to the subject's face, hands, and arms that continuously monitored and recorded the trader's physiological characteristics such as skin conductance, heart rate, respiration, facial and forearm muscular activity, and body temperature. The sensors were connected to a small control unit on each subject's belt, and from each control unit, a fiber-optic connection led to a laptop computer that analyzed the real-time physiological data using biofeedback software while simultaneously recording corresponding real-time financial data on which the traders based their decisions.

These monitoring devices, similar to ones used in cognitive studies of decisionmaking by automobile drivers and student pilots in flight-simulators, did not interfere in any way with the traders' normal activities. The monitors tracked the subjects' physiological responses before, during, and after three kinds of "market events": deviations, trend reversals, and periods of increased market volatility. Such events are known to generate heightened attention and awareness among even the most experienced traders.

The market data used in this study consisted of prices and bid/offer spreads in 15 key financial instruments: 13 foreign currencies and two futures contracts. The authors analyze both physiological and market data to address three objectives: to identify particular types of events that seem to yield statistically different autonomic responses from "control" periods (periods containing no events of any kind); to identify differences in autonomic responses between particular traders or groups of traders based on trading experience or other characteristics; and to identify differences in autonomic response associated with differences in the particular financial instruments traded.

The results show that physiological variables associated with the autonomous nervous system are clearly correlated with market events. Although the physiological responses of experienced and inexperienced traders show some interesting differences, even the most highly experienced subjects exhibit significant autonomic responses during market events. Such patterns, say Lo and Repin, strongly suggest that emotional responses are a significant factor in the real-time processing of financial risks, even among the most rational investors in the economy.

These findings support other studies that point to the significance of cognitive-emotional interactions and the genesis of what, for the lack of a more precise term, we call "intuition." Experts' judgments, the researchers maintain, are often based on this subconscious process of intuition, and not necessarily purely on explicit analytical processing.

In fact, the data suggest that the most successful traders often seem to function without the ability (or need) to articulate the reasoning behind their decisionmaking. A reasonable conjecture, say Lo and Repin, is that emotional mechanisms are at least partly responsible for the ability to form intuitive judgments and for those judgments to be incorporated into rational decisionmaking. Such a conclusion, they add, may not be as puzzling as it seems.

According to cognitive scientists, emotion is the basis for a reward-and-punishment system that facilitates the natural selection of evolutionarily advantageous behavior. From an evolutionary perspective, emotion is a powerful adaptation that dramatically improves the efficiency with which animals learn from their environment and their past.

In this respect, it would appear that emotion is a significant determinant of the evolutionary fitness of financial traders. In short, since unsuccessful traders are generally "eliminated" from the population after a certain level of losses, the authors conjecture that the presence of emotion in the financial community is, in a Darwinian sense, desirable. Lo and Repin believe their findings are promising enough to warrant further investigation on a larger scale and with a more refined set of experiments and tools.

-- Matt Nesvisky

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