Trading on emotion: traders, reason and emotion in financial markets

Updated Friday 16th May 2008

What part does emotion play in the ups and downs of financial markets?

In January 2008, the press were full of reports of the impact of Jérôme Kerviel’s impact on world stock markets. This trader cost Société Générale €4.9 billion by hiding trading positions he should never have taken. The impact of these trades being unwound is widely believed to have been a significant factor in the decline of market values around the world. Press reports at the time such as this one in the Times were full of phrases like global crisis, panic, nervous traders fears’. This story unfolded as it was becoming clear that the impact of the overinvestment in poor quality ‘sub-prime’ housing loans in the USA was tuning into a major threat to economic stability around the world. The effect has been that institutions, which were once blithely lending money to all and sundry almost regardless of ability to repay, have become fearful of lending even to each other. As this story has unfolded there has, again, been an important subtext of emotion in markets (for example Buy Panic: Gene Marcial on How Market Meltdowns Can Be Your Ally).

New York Stock Exchange Creative commons image Icon Helico used under a creative commons licence under Creative-Commons license
New York Stock Exchange.

Emotion in financial markets is not all about fear and panic. We know for example that, on average, prices on the New York Stock Exchange are higher on sunny days than on cloudy days. Sunny weather tends to make us feel more optimistic and it turns out that professional traders are no exception.

Meanwhile recent work by Cambridge University neurologists John Coates and Joe Herbert has shown a significant link between traders behaviour and the levels of hormones, such as testosterone, which have important links to emotion.

This is all in complete contrast to financial economists accounts of market behaviour which see investor decisions as driven by rational analysis, and prices as perfectly reflecting rational analysis of all available information.

So should we simply conclude that traders need to get a better grip on their emotions, calm down and start making rational decisions on the basis of considered analysis? Certainly my own research (with colleagues Nigel Nicholson, Emma Soane and Paul Willman) shows that learning to regulate their emotions is an important part of traders learning as they gain experience. As one trader told us:-

“I would cite myself as a great example of someone who started trading when I was 18 and got terribly emotional about everything, every loss; and I’d lie awake at night and think everything through and try and replay the tape - I wish it happened a different way … Over time you realize that nothing matters and you not only realize that nothing matters in here, it doesn’t matter outside here either. It took me a long time to get that.”

However our research, which involved detailed interviews with 118 traders and their managers, also seemed to suggest that learning effective emotion regulation is not simply learning to set feelings aside. In the fast paced world of trading, rapid decision-making is at a premium; and the emotional cues and hunches that come from long experience can be an important aid. Rather than emotionless machines, high performing traders were often aware of their emotions. They used them as important sources of information; but were not at their mercy. Our findings are supported by a recent study by Myeong Seo and Lisa Barrett (220K PDF) who found that stock investors who were better able to identify and distinguish among their current feelings outperformed other investors.

As we learn more about the ways in which human cognition and emotion are inseparably entangled it is becoming clear that emotional competence is not just important to our relationships, it is a vital element of success in the world of high finance.

If you are interested in learning more about decision-making, you can find a free course designed by this author on Openlearn: Making decisions. You can also find a free course which gives a financial economics perspective on markets: The financial markets context.

 

For further information, take a look at our frequently asked questions which may give you the support you need.

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