all-time high of the NASDAQ, JimCramer published a rewrite of his wife’s 10 trading commandments onTheStreet.com. Her fourth trading commandment addressed the paralysisaccompanying extreme stress—a consequence of unbearable losses:
If you feel like a position of yours is going to drown you in yourown pool of losses, please the trading gods and throw a maiden inthe volcano. . . . (I can’t tell you how important it is to haveyour head clear. The only way to clear it when you are hav-ing the &(&*%*% knocked out of you is to take a small loss.It loosens the vise and allows you to think again. You need tobe clear-headed to make money. If there is a position that isdogging you, take some of it off, throw the maiden in the vol-cano and please the gods. This is not as silly as it sounds. Youwill breathe regularly and you will be able to make a betterdecision. Also you will have your eyes open for the next bigchance.) [original bold]5
CHOKING FOR RUPEES
Dan Ariely is a psychology professor at Harvard where he frustrates (withbrain puzzles), shocks (electrically), freezes (in cold water), and otherwisestresses out his student volunteers. None of his experiments threatens per-manent damage, but they do have interesting effects on participants’ stateof mind. Ariely induces and Cramer describes market-style stress.
In high-pressure environments, where a lot of money is at stake, whydo many people “choke”—underperforming their actual abilities? Arielywas curious about the effect of ﬁnancial incentives, such as end-of-yearbonuses, trying to close a large deal, and stock market gains and losses, onindividual performance. The conventional assumption was that higher payleads to better performance in such incentive-based decisions, but Arielysuspected that such an assumption is inaccurate.
When designing an experiment to investigate choking, Ariely quicklyrealized that he couldn’t afford to run the study in the developed world.
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He thought salaries in the United States and Europe were too high for hismeager research budget to make an impact on subject decision making.Having already developed a network of university students in India, Arielytraveled there to run his experiment in one of his students’ home villages(where average salaries were incredibly modest). Workers in the chosenvillage spent, on average, $10 per month.
Ariely designed his experiment so that subjects would play one of sev-eral different types of games. Some required superior cognitive skills, andothers demanded physical performance in the effort to earn a large jackpot.The highest-paid players could earn several weeks’ expenses based on oneoutstanding performance. They could earn a total of six months’ expensesif they executed the tasks perfectly. To his subjects, Ariely’s ﬁnancial re-wards seemed enormous.
Ariely divided the subjects into three groups. In each task, the ﬁrstgroup received 0 Indian rupees (Rs) if they performed poorly, 2Rs if theydid “good,” and 4Rs if they had “very good” results. The second groupplayed for 0Rs, 20Rs, or 40Rs depending upon their performance, whilethe third group could win 0Rs, 200Rs, or 400Rs. The third group was play-ing for, relatively speaking, very high stakes. (Approximately 45Rs equalUS$1).
Subjects played several different tasks, including the classic mem-ory game Simon, the concentration game Labyrinth, and the motor skillsgame Dart Ball, among others. Subjects played each game 10 times. Theyachieved “very good” performance if they accomplished a predeterminedsuccess criterion. Eighty-seven subjects participated, with one-third se-lected randomly for each payoff group.
Ariely found that participants in groups 1 and 2 had a statisticallysimilar rate of achieving “very good” results, approximately 30 percent ofthe time. However, participants in group 3, who were playing for severalweeks’ expenses in each game (the equivalent of over $2,000 for the av-erage American), performed worse than the other groups, achieving “verygood” performance only 10 percent of the time. Playing for high stakes sab-otaged their performance.6
In many experiments where subjects make large amounts of money,they often relax their attention as their wealth accumulates, decreasing therate of their earnings. Interestingly, Ariely found no such “wealth effect.”Subjects in Ariely’s experiment who initially earned large gains did not ex-perience performance reversals during the later tasks.
Outsiders who were asked how they thought people would do inAriely’s experiment predicted that performance would improve as theamount of money at stake increased. In general, most people are unawarethat stress over high stakes will adversely affect their performance. If
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they had such insight, they could take preemptive action against excessstress—performing relaxation exercises or using cognitive reframing tech-niques.
Among some ﬁnancial market professionals—investment bankersclosing large deals and negotiators for single high-stakes outcomes—choking is more likely. In many ways, “choking” stress is purely percep-tual: we think that stakes are high, but as in Ariely’s Indian experiment,“high” stakes are relative to one’s context and experience.
WHICH GOES WRONG—THE BRAINSOR THE BRAWN?
Ariely had found that performance stress caused “choking” among themost highly rewarded subjects. Yet it wasn’t clear to Ariely whether stresswas impairing the subjects’ cognitive or physical performance. For exam-ple, it was possible that stress did not impact their thinking, but rather it im-paired their dexterity and motor coordination. In order to verify his resultsin the developed world and clarify whether the decreased performance wasprimarily due to the motor or cognitive effects of stress, Ariely designed anew experiment for Massachusetts Institute of Technology (MIT) studentvolunteers.
In the motor task, subjects were asked to type a series of letters on akeyboard as rapidly as possible. On the cognitive task, subjects were askedto ﬁnd two three-digit numbers (e.g., in the format 1.23) whose sum was10. These numbers were hidden within a 3 × 3 matrix of like numbers.Students with “very good” performance on either the motor or the cognitivetask could earn $300.
Ariely found that as task payoffs increased, motor skills increased, butcognitive skills decreased. Importantly, subjects performed worse at themathematics task when more money was at stake.7 According to Ariely,this cognitive decline when under stress is due to a shift in decision-makingstrategy. Under stress, the brain shifts its processing and decision func-tions from “automatic” to “manual” control. “Manual” control implies thatthe participants are overthinking their task strategy. The brain’s realign-ment to a “manual” strategy is unconscious and very difﬁcult to reverseonce play has begun. Recall that a similar effect—the distortion of intu-ition by conscious analysis—was discussed in Chapter 5.
As stakes increase, investors have trouble using smooth intuitive deci-sion making. When they realize that the amount of money at stake in theirinvestments is larger than ever before, they can easily lose their focus and
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concentration. They inadvertently shift from automatic to manual cogni-tive control, and this shift ruins their ability to ﬂuidly respond to marketevents.
In a third experiment at MIT, Ariely examined the role of socialobservation on performance. Participants were asked to solve anagrams(mixed-up collections of letters that spell a word when decoded) either atprivate cubicles or on a blackboard in front of three people. Performancewas rewarded ﬁnancially. Subjects who solved the puzzles in privatesolved 1.16 anagrams per minute, while subjects who solved publiclyﬁgured out only 0.67 per minute. Being observed had a strong detrimentaleffect on cognitive performance.8
Many ﬁnancial planners, advisers, brokers, and portfolio managers ex-perience the stressful effects of observation on their performance. Whenclients are closely watching a manger’s gains and losses, the manager’s in-vestment skills are likely to be constrained. Besides the disproportionatetime they require, this may explain why nervous and controlling clients areso irritating to many ﬁnancial planners.
Hedge fund managers who utilize a two-year lock-up of client fundsmay feel less social pressure, though quarterly reporting requirements pre-vent true independence from client observation.
STRESS AND TREND PERCEPTION
The following study demonstrates that stress intensity is not only propor-tional to how bad things actually are. In fact, much of the stress responseis generated by perceptions of a worsening in conditions. A “really bad” sit-uation that appears to be improving to “pretty poor” status provokes relief,while a “neutral” situation that is worsening toward “poor” can be quitestressful.
Researchers examined the stress responses of two groups of rats afterthey were subjected to painful electric shocks. Group 1 received painfulelectric shocks 10 times per hour, while Group 2 was shocked 50 timesper hour. The second day, all rats were shocked 25 times per hour. At theend of the second day, rats from Group 1 (who experienced an increasein shock rate) had elevated blood pressure (a physical sign of stress). Ratsfrom the second group (who experienced a decrease in shock rate) hadnormal blood pressure.9 Why the difference?
The rats were responding to the perception of a worsening or improv-ing situation. The Group 1 rats were in a worsening situation. On day two,the rats in Group 1 were stressed to experience 25 shocks per hour, whilethe Group 2 rats were relieved to be subjected to the very same event.
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In the markets, if investors believe that the economy is going from badto poor, they may feel relieved and subsequently buy stocks. On the otherhand, if they believe that the economy is going from neutral to poor, thenthey will feel stressed and will prepare for increased economic risk by sell-ing stocks. Perceptions of future stress are felt now.
NEUROCHEMISTRY OF STRESS
When people worry or get stressed out, their bodies secrete chemicals thatprime them to ﬁght, ﬂee, or perform other quick evasive actions. Animalsunder stress relieve their discomfort by acting, but humans are usually leftto simmer in their stress hormones, often never acting out in a way thatrelaxes the stress response.
The psychological effects of acute stress response are often adaptive:“If you’re in dangerous conditions it helps to be distractible, to hear everylittle sound in the woods and react rapidly, instinctually. . . . It’s like gettingcut off on the highway. You don’t want to be a slow, thoughtful creature.. . .You want to react and hit brakes.”10
Chronic stress results from a series of acutely stressful events thatchemically “prime” the body for adverse circumstances. Over time, thebodies and minds of the chronically stressed adapt to the chemical prim-ing agents, resulting in the negative physical and mental effects describedbelow.
The chemistry of the human stress response is understood as resultingfrom two primary brain pathways. The immediate stress response preparesthe body for urgent struggle. Within seconds the sympathetic nervous sys-tem (SNS) is activated. A small nerve bundle in the brain stem called thelocus ceruleus (see Figure 10.1) releases norepinephrine, triggering a cas-cade of physical preparations for struggle. The SNS is a network of nerveﬁbers running to large skeletal muscles, the heart, the skin, the diaphragm,and the sphincters (among other areas). When SNS nerves ﬁre in alarm,physical signs such as trembling, perspiration, rapid heart rate, shallowbreathing, and pupillary dilation occur. The SNS is responsible for the phys-ical reactions to acute stress and panic.
The second neural pathway manages the stress response over min-utes to hours. During acute stress, a signaling hormone is secreted fromthe hypothalamus, which travels via the bloodstream to the pituitary glandwhere it triggers the release of a second hormone, adrenocorticotropic hor-mone (ACTH). Via the bloodstream, ACTH travels to the adrenal glands,where it triggers the release of cortisol and epinephrine (adrenaline). Thehypothalamic-pituitary-adrenal (HPA) axis is the control structure of the
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HYPOTHALAMUS
PITUITARYGLAND
ADRENALGLAND
CORTISOL ANDEPINEPHRINERELEASE
FIGURE 10.1 Hypothalamic-pituitary-adrenal (HPA) axis. The stress hormonestravel through the bloodstream and trigger a cascade of physical and hormonal re-actions.
chronic stress response, involving the interactions of the hypothalamus,the pituitary gland and the adrenal glands.
The interactions between the rapid and slow stress responses are vari-able, depending on the nature, intensity, and duration of the stressor. Oneof the most straightforward ways to measure short-term and chronic stressis via levels of the hormone cortisol, which can be sampled in saliva (cheekswabs) or blood (vein draws). Cortisol levels naturally vary throughout theday, rising in the morning from 4 A.M. to a daily peak 30 to 45 minutes afterawakening. One’s cortisol level then slowly declines until a smaller late af-ternoon peak, and later begins a precipitous drop at 10 P.M. until the 4 A.M.trough.
Beyond daily variations, cortisol levels are also raised by threat percep-tions. There are anatomical connections among the amygdala (the brain’surgent fear center), the hippocampus (the memory center), and the hy-pothalamus (the HPA axis control center), which facilitate cortisol releasewhen a threat is recognized.
BIOLOGICAL EFFECTS OF STRESS
The biological effects of stress are many. Atrophy of the hippocampus, dueto severe stress, results in poor concentration, short-term memory loss,increasing impulsivity, and difﬁculty delaying rewards (time discounting).
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Chronic stress impairs immune system functioning and increases suscepti-bility to viral and bacterial infections.11,12 Weight gain and high blood pres-sure can result from chronically elevated stress hormones.
Behaviorally, passivity follows from stressful experiences. Highcortisol levels in monkeys undergoing stress are correlated with conﬂictavoidance and decreased aggression.13 There are also indications thatlower social rank leads to chronic stress and ﬂattened cortisol levels.
Stress, especially uncontrollable stress, elevates levels of a brainenzyme called protein kinase C (PKC). PKC affects parts of the braininvolved in abstract reasoning, concentration, and short-term memory.High PKC levels impair short-term memory, concentration, focus, andjudgment. Additionally, high levels of PKC increase impulsivity andsusceptibility to thought disorders (such as delusions).14
According to one stress expert, stress is most damaging when one feelsa loss of control: “It doesn’t have to be traumatic, as long as you feel out ofcontrol,” she said. “Control is the essential factor. . . . If you are conﬁdent,you don’t have these problems.”15 Unfortunately for investors, control isexactly the thing they lack over the markets. Therefore, to manage invest-ment stress, control must be exerted where it will have an effect, such asin designing bulletproof money management systems, performing superiorresearch, establishing a solid investment philosophy, and communicationwith clients.
ADRENALINE JUNKIES
If only it were so simple as “stress = bad” and “cortisol = bad.” Yet“adrenaline junkies” and “roller-coaster riders” enjoy recreational stress.There is a paradox here. For most people, moderate stress, over a shortperiod, feels good. Successfully coping with moderate stress can have ben-eﬁcial physical and emotional effects.
In the brain, moderate amounts of cortisol facilitate dopamine releasein the reward pathways. The essence of enjoyable stress is the knowledgethat it is taking place in a safe and benign environment, is under control(someone can stop the ride if a malfunction occurs), is somewhat unpre-dictable, contains surprises, and occurs over short periods—seconds in thecase of slot machines, and minutes in the case of a roller coaster.
Most investors enjoy the rush of trading. They like taking risk andsavoring the thrills of the market roller coaster. A number of ﬁnancialplanners recommend setting aside a small percentage of one’s total capitalfor recreational trading. This allows retail investors to get a thrill usinga small portion of their total assets without jeopardizing their long-termﬁnancial security.
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MANAGING INVESTMENT STRESS
In general, if a stressful event is predictable, then it evokes a decreasedstress response. The markets are anything but predictable, leading togreater stress among investors who are trying to forecast future pricemovements. If one becomes acclimated to a stress trigger (such as the fearof heights for an experienced parachutist), then the stress response dimin-ishes to almost nil. Experienced traders do in fact have decreased stressresponses to market volatility, but not improved performance.16
Some ﬁnancial information predisposes investors to stress. The waythat price and order information is displayed taxes cognitive resources.Traders who watch price quotes, tick by tick, are particularly susceptibleto chronic stress and burnout. The more one checks stock quotes, the morelikely they are to see volatility. When the brain weighs every downticktwice as heavily as every uptick (as described in Chapter 14), the brainundergoes a slow stress erosion. To prevent stress when observing marketprices, avoid watching current positions unless they hit a predeterminedalarm level (most brokers offer such alarms). Additionally, it can be veryhelpful to reduce ambient noise. Pressures to multitask during the work-day, unless you ﬁnd those distractions useful for macro pattern recogni-tion, should be minimized.
Many traders can tell a woeful story about the time they shifted theirattention during the trading day, maybe to an urgent phone call from afamily member, and when they returned to the markets they had lost ahuge sum. It’s crucial to minimize distractions during the workday.
Stress is increased by such a lack of control and a perception of con-ditions worsening. Researchers found that dogs who were given electricshocks that they could terminate by making body motions got fewer ulcersthan “yoked” dogs who were given identical but uncontrollable sequencesof shocks.17 Our perceived ability to exert some control over a noxiousevent reduces the amount of anxiety and distress we experience.
Many investors operate in isolation from others, acquiring informationvia impersonal computer monitors or telephone calls with strangers. Socialsupport diminishes the stress response, but many investors have little inti-mate contact with their families, friends, and even colleagues. Attendanceat professional social groups, such as the Technical Security Analysts As-sociation, can be very helpful for ﬁnding social support from others dealingwith the same challenges in the markets.
Many great investors report that constant information monitoring,while isolating them from their family, helps them to identify developingopportunities before others. Yet, in order to spend more quality time withfamily or friends, it’s helpful to set strict boundaries on the informationthat one will monitor after hours.
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Investors need to be prepared for every contingency. As positionsdeteriorate and stress levels rise, the brain becomes cognitively inﬂexibleand unable to think of solutions. Suddenly, panicking out of bleedingpositions may appear the only viable option.
SUMMARY
Stress affects every market participant, often in very different ways. Fi-nancial advisers working with difﬁcult clients and proprietary traders involatile markets have very different stressors, but their bodies’ responsesare the same.
Investors making high-stakes transactions are susceptible to “chok-ing.” As seen in Ariely’s Indian study in this chapter, choking caused two-thirds fewer subjects to exhibit “very good” performance when they wereplaying for the highest payoffs. The choking was caused by a performance-deteriorating shift from “automatic” to “manual” control of decision mak-ing and behavior. The effects of stress were entirely cognitive, as motoraccuracy and speed actually increased in stressed subjects.
Short-term stress triggers hypervigilance, physical preparedness foraction, and attention shifting. Acute stress leaves an “action-potential”residue that lingers until it is discharged. Many people develop stress-related disorders because they chronically do not discharge theirstress-primed action tendencies. This may be one reason why exercise isso beneﬁcial for health—it discharges the physical action potential.
Chronic stress shrinks the hippocampus and impairs memory, learn-ing, mood, and sleep cycles. Additionally, the chronically stressed havelowered immunity and increased susceptibility to chronic illnesses.
Moderate stress triggers dopamine release in the reward system andpromotes learning and development. However, stressors that are unpre-dictable, uncontrollable, or of worsening severity provoke a more negativestress reaction.
Professionals who experience overwhelming stress may “throw amaiden in the volcano” (sell part of a stressful position) to relieve someof the stress intensity and regain their automatic, intuitive decision-makingcapacity. Social networks, exercise, and self-discipline in money manage-ment are essential to stress reduction.
The next chapter is a cautionary tale of the tragic consequences of gam-bling in the ﬁnancial markets.
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C H A P T E R 11
Love of RiskAre You Trading or Gambling?
“We should know that too much of anything, even agood thing, may prove to be our undoing . . . [We]need . . . to set deﬁnite boundaries on our appetites.”—William J. Bennett1
D uring the lunch break at a mutual fund industry conference, I
mentioned to my neighbor at the lunch table that I’m an in-vestment psychologist. I was overheard by someone a few seats
away.
Andrew was seated across the table, and it was apparent that hewas interested in my profession. He got my attention and said, “Let’stalk.”
“Sure,” I responded. He stayed seated and didn’t say anything else until
the end of lunch.
After about 20 minutes, the chair to my left emptied. Andrew movedinto the vacant seat. He was about 60 years old, short and portly, with amischievious shine in his eyes. He had physical presence and charisma.
Andrew said he was a broker-dealer in Fairﬁeld, Connecticut, awealthy exurb of New York City. He wasted little time getting to his point.“Richard, I need to talk to you.”
“Okay,” I responded.“I want to talk about trading.” His tone was matter-of-fact, but there
was a tremor in his voice.
“All right. Do you want to talk about it here, now?” I asked.“What is you opinion of Netﬂix stock?” He asked abruptly. (Netﬂix is
an online movie rental company.)
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I began to explain my limited thoughts on Netﬂix.“What do you think about Baidu?” (Baidu is a Chinese Internet searchengine and was a recent initial public offering [IPO] on the U.S. stockmarket.)
I reoriented myself. As I started to ask why he was interested, he againcut me off. He didn’t care to hear my stock opinions. Something else waseating at him. He ﬁxed a long stare on me, and he then he began the realstory.
“I have hunches, and I follow my hunches,” he said. “Over the last few
years, my hunches have been very good to me.”
He looked at me thoughtfully. “Can I tell you something that’s very
personal?” I nodded.
“I have lost $7 million dollars since January.” He paused for effect.“What happened?” I asked.Andrew explained that he had made, and subsequently lost,multimillion-dollar sums three times over the past two years in his personalaccount. A year previously he took out a home equity loan for $500,000 toplay one of his hunches in the markets. His hunch was that Netﬂix stockwould soar over the next three months. He bought calls, using almost theentire $500,000 on one undiversiﬁed bet.
Fortunately for Andrew, he was initially right—Netﬂix rallied allthrough the spring of 2005, and he made $4 million. Then he got a hunchabout eBay stock. He again bought calls—$3.75 million worth. eBay’sprice stayed ﬂat, with brief terrifying downturns and short-lived, buthope-inspiring, rallies. By the Monday of options expiration week, his callswere worth only $650,000. By Friday, they had expired worthless. He hadonly $250,000 left in his account from his original $500,000 home equityloan. He let that money sit in his account for three months until his nextbig idea emerged.
In October 2005, he got another “hunch” about Netﬂix stock. He boughtas many calls as he could. As Netﬂix climbed over the next three months,he rolled them over into the front month each month through December.As their value increased, his account ballooned to $7 million. He took a tripto Kansas to see his extended family over the winter holidays, and he lethis positions ride into the new year.
Andrew told me, “Maybe I never should have left those positions open,but I couldn’t think straight anymore.” On the ﬂight from JFK to KansasCity, he recalls, “I couldn’t get it out of my head—I could have bought theticket of everyone ﬂying to Kansas that day. I was intoxicated with themoney, and I didn’t know what to do.”“So what did you do?” I asked.“Nothing,” he said.
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“What do you mean ‘nothing’?” I was stunned that he (1) didn’t havesome type of strategy and (2) lost $7 million he couldn’t afford while hewas on vacation for three weeks.
“When I got back they were worth a lot less—maybe $700,000. ThenI rolled them over for the next two months and they eventually expiredworthless. Today, I have $81,000 left—that’s all, and it’s all in out-of-themoney Baidu calls that expire in three weeks.” His speech became pres-sured. “And you know what’s the worst thing?” he asked me. “I owe mil-lions of dollars in capital gains taxes. I didn’t sell any of my positions toraise money for taxes. Now I don’t have the money. I don’t even know howI’m going to pay for my kids to go to college anymore. I have to pay thehome loan back.”
His short-term trading proﬁts had led to a massive IRS bill at the turn ofthe year while he was in Kansas. And then he had lost everything, includingthe money to pay the taxes. He was in debt $2.7 million to the IRS.
After the conference’s afternoon workshop, Andrew invited me to lookat his brokerage account ﬁgures on his laptop. He showed me the highs andlows of his statements over the past year, month by month. He had beentaking on so much risk that he was virtually guaranteed to go broke. His“risk of ruin” was 100 percent.
As we were looking at his account statements, Andrew repeatedly toldme, “I should have sold when I had $7 million. If only I’d sold when I wasup.”
After we examined his trading records, Andrew asked me point blank,“Do you think I’m a gambler?” He was a broker who certainly had seen afew wild speculators at some time in his career, yet he couldn’t identify hisown behavior.
He thought the problem with his boom-and-bust trading proﬁts lay inthe markets. He had a series of “what if” questions tailored to avoid takingresponsibility for his terrible performance: “What if I hadn’t gone to KansasCity?,” “What if I hadn’t bought more calls in January?,” “What if I had paidmore attention to the markets?”
Yet, just like him, I couldn’t help but wonder, “Andrew made a 10-foldreturn three times over the past two years. While his risk management issuicidal, what about his hunches? Could he be doing something right?” It iseasy to be seduced by short-term, but unsustainable, proﬁts.
Investors who make a big win early in their careers are more likely todevelop a gambling problem in their investing style. Perhaps because theyattribute their success to an innate skill or talent, and not to random luck,they spend many years trying to revisit their