IN THIS CHAPTER

Seeing how human evolution has impacted financial decision-making processes

Looking more closely at the trader brain

Understanding neural circuits and biochemical processes

Tracing the miracle of neuroplasticity

Using process orientation for success

In this chapter, I take you way back — way, way back. Across millions of years, the evolutionary selection process has made us humans what we are today. We must take that knowledge into account when we’re surprised about behaviors that no longer fit in our modern time — including behaviors on the trading floor. To better understand what’s going on, it pays to take a closer look at the trader brain. (I hope to convince you that this closer look will provide some answers.) Modern brain research has made some exciting discoveries about how the decision-making process actually takes place — which parts of the brain are involved and which biochemical processes occur simultaneously, for example. In fact, the research has progressed to such an extent that experts in the field are able now to predict financial decisions by the activity of specific areas of the brain.

By their very nature, your brain and its interconnections are not quite suitable for the trading business. But you can train them to overcome their inherent weaknesses. The human brain is changeable and can adapt to changing conditions. In other words, you can learn behaviors for successful trading — brain-compatible trading, in other words.

The key to successful trading is process orientation — what I call the systemization of your trading approach. You need professional rules and a proven trading strategy in order to survive in unpredictable markets. When you add that to a trading style that suits your personality, there may not be much holding you back when it comes to a successful trading career.

Recognizing the Human Barriers to Trader Success

In the last decades, science has closely investigated human behavior in the area of economic decision-making. The findings are sobering. The science tells us that humans are characterized by emotional patterns of thought and behavior that have been formed in the course of evolution. The science is also telling us that there's a good chance that these subconscious automatic behaviors are unsuitable when it comes to making wise financial decisions. In numerous studies, behavioral economists have demonstrated how irrational humans are when they’re making investments. The truth is, financial decision-making behavior can be distorted by many factors, including these:

• Overestimating your abilities
• Learning from your mistakes seems beyond your power
• Letting emotions, such as fear and greed, unconsciously determine your behavior when making financial decisions
• Letting yourself get carried away by the crowd
• Being unable to objectively assess risks
• Letting the situation — rather than calculation — determine your appetite for risk
• Taking profits too early and letting losses run on

Taking a closer look at the brains of investors and traders demonstrates why the failings listed here occur and how they impact the decision-making process. Laboratory experiments within the relatively young field of neurofinance provide some exciting answers.

Using Neurofinance to Look Deep Inside the Trader Brain

Neurofinance is an interdisciplinary area of research that resulted from the combined efforts of economists, behavioral psychologists, and neuroscientists in the 1990s. Neurofinance research, by making use of modern brain research methods, focuses on analyzing financial decision-making processes. These are the central questions: How does the human brain deal with money? Which neural structures are involved in processing financial decisions? What is the importance of the biochemical processes in the brain when it comes to dealing with money? Neurofinance studies of the drivers of choice behavior pay special attention to the trading behavior of financial market actors, focusing on the central question of how behavioral and cognitive biases distort the rational decision-making of investors. Another aspect is the influence of personality traits on investor behavior.

The neurobiological correlates of financial decision-making processes have been decoded. A brain scanner can display the enormous influence of emotions, cognitive biases, and archaic instincts in real time. Most of the time humans may not act rationally. Many of the phenomena described in behavioral finance research can be explained by taking a closer look at the trader brain. Today, brain researchers are able to predict and influence investor behavior.

Professor Bernd Weber, a clinical neuroscientist and dean of the Medical Faculty at the University of Bonn, has come to the conclusion that, because of their evolutionary development, humans are incapable whatsoever of rational thinking and acting. That would also suggest (quite highly, in fact) that the human brain simply isn’t made to invest successfully in the stock market. The laws and functioning of financial markets contradict learned human behaviors.

The neural networks in the human brain have developed over the past million years and have adapted to the respective living conditions faced by said humans. We today are the result of an evolutionary selection process, where the genetic makeup and the structure of the human brain has changed incredibly slowly. As a matter of fact, according to leading neuroscientists the human brain hasn’t changed much over the last 50,000 years. In the face of the rapid developments of the world in the last centuries, evolution has been unable to keep up. Unconscious and highly automated behaviors probably arose as the best possible adaptation to prevailing environmental conditions. Automated behaviors when faced with threat situations probably kept humans alive in the Stone Age (fight-or-flight reflex), but present-day threat situations still trigger the same stimulus-response patterns.

The living conditions of the human species have changed drastically, but evolution isn't that fast. The human brain comes from another time. Deeply rooted instincts still determine our behavior, especially when we are under emotional duress. These instinctual mechanisms do not suit the ways present-day financial markets function. Humans are conditioned to act, while the stock exchange often rewards patience and waiting.

Is our evolutionarily ancient brain system even suited to make sensible trading decisions? Neurofinance research has answered this question with a resounding No. We were given a brain to help us survive in a harsh environment; its nature isn’t suited to making economically rational decisions in complex financial markets.

Recognizing Typically Human Behavioral Patterns

Today we understand that our brain, over the millennia, has always tried to adapt in the best possible manner to our respective living conditions. In comparison to the millions of years of our history of evolution, the past centuries are only a tiny window of time, but one with a dynamic speed of change that never occurred before this. That means the neural circuits in our brain may require a few generations until they have adapted to modern life.

Therefore, it should come as no surprise that the behavior and thought patterns of many market participants aren’t always rational and therefore can be explained better within an evolutionary context.

Deeply rooted reflexes and unconscious reactions from previous epochs seem to determine our financial decisions. This applies to individual traders as well as to the majority of market participants. Strong price movements are emotionally contagious and can lead to collective herd behavior. That’s why the stock exchange is, at its most fundamental level, psychology. To fully comprehend the psychological nature of the stock exchange, you must realize that the dominant emotions experienced there stem from another era and that they are characterized by irrational exaggeration in both directions. Speculative bubbles and stock market crashes repeat at regular intervals, as the history of the stock market shows.

This may sound quite sobering for traders, but it explains market realities.

Don’t let yourself be fooled: The neurobiological prerequisites for successful trading are not a given.

But there is hope: You can balance many human inadequacies and learn to acquire the necessary equipment for brain-compatible trading. It requires a lot of practice and training. Self-awareness and self-reflection are the first step. As a trader, you should understand and accept how your brain works. Be clear that the structure of your brain isn’t suited to financial market mechanisms. You have no other option but to accept that fact. You have only one brain.

You can’t change anything about your genetic makeup, but you can learn to deal more consciously with your emotions and natural reflexes. You need to do so from the position of an objective observer. When you learn to perceive your response patterns in a more conscious manner, you can avoid all sorts of evolutionary traps. You'll be in a position to adapt your behavior to markets by observing, analyzing, and following the markets in a conscious manner.

Our expert knowledge and our own analytical logical powers of thought can be called up only when we can reduce the negative impacts of emotions. This is the only way to be balanced and in full possession of our cognitive capacity — with unfiltered access to our intellect and intuition.

The discoveries of modern brain research can build a bridge between the realities of human behavior and the way that financial markets function. Neurofinance can provide you with an important set of tools as you make your way down the path to becoming a successful trader.

Leveraging Neuroscientific Discoveries

Accepting the limitations of the structures of your brain initially sounds frustrating. However, modern brain research has some good news: The human brain isn’t hard-wired — it’s capable of change throughout our lives.

Fifty years ago, science was still convinced that human brains were fixed and incapable of change. Today, we know that the central nervous system and our brain slowly but steadily change in response to our actions and experiences over the course of our entire lives.

Neuronal (also known as synaptic) plasticity refers to the ability of our brain to change and optimize processes and sequences when used effectively. To simplify, one can say that the brain works like a muscle: When you don’t use neuronal structures and synaptic connections, they tend to degrade over time. Networks you do use intensively tend to stabilize and strengthen over time. This is visible on a brain scanner and can be easily recognized.

The psychologist Donald Hebb is considered to have discovered synaptic plasticity. In 1949, he formulated the learning rule named after him (Hebb’s rule) which states that learning processes take place in neural networks by means of synaptic transfer between neurons (in other words, “Neurons that fire together wire together”). Consistent repetition creates stable new connections and strengthens memory.

Neuroplasticity always works in both directions, independent of age. By that, I mean that you can

• Lose abilities if you don’t use them
• Learn abilities if you practice them consistently

You probably use a navigational system when you're driving in an unknown area. (It’s practically basic equipment for cars these days.) This leads to cognitive offloading, where the hard work of cognitive processing is shifted to somebody (or something) else. (The evidence for such cognitive offloading is quite clear, as research on brain scanners shows.) Research has proven that our natural orientation skills significantly worsen with the use of navigational systems.

The determining factor in learning any new skill is regular repetition. Practice makes perfect, as the old saying goes. We can do anything we want if we practice regularly and intensively. Abilities aren’t genetic; there is no natural talent for trading. Because it’s now a simple matter to open a trading account and just start trading, lots of newbies underestimate the amount of time, stamina, and practice required in order to trade successfully.

According to best-selling author Malcolm Gladwell, you can achieve anything with discipline and hard work. In Outliers, his book from 2008, he explains how extremely successful people — athletes and professional musicians, for example — train on the average for 10,000 hours over the course of their career. Practice is much more important for success than talent, the author claims.

Trading Success Factors

Even if current studies on the topic of peak performance in general come to the conclusion that talent is the most important factor when it comes to success, this applies to only a limited extent to the trading business. If you want to be successful in trading, you require large measures of motivation, discipline, and stamina. All three have more to do with attitude than with talent. Without the appropriate mindset, you won't achieve your goals. If you want to master your field, you need to develop constantly and train consistently. Expert status will not just fall from the sky and you certainly don’t get it at birth. Training and performance are tightly linked — no doubt about it.

In looking at trading success, I've determined that there are a few basic success factors, all of which can be divided into these four main areas:

• Processes
• Practice
• Personality
• Talent

The secret to success in trading is to have clear processes and structures as well as predefined strategies and trading plans. You must train for these, until the fixed sequences become part of your flesh and blood. Routines provide you with the support and stability you need in stressful situations without having to think about them. Habits keep your head free, saving cognitive energy that you can use for more important tasks in trading. Formulated in a neuroscientific manner: Repetition builds and consolidates the neural circuits of process orientation until they can be recalled automatically. This doesn’t sound particularly exciting, but it’s the key to success. After all, your behavior won't change by changing your opinion. A new conviction is formed only when you have drilled the new behavior into you.

Trading is a particular psychological and emotional challenge that humans aren’t ready for in their natural state. Tried-and-tested processes provide you with security and prevent old reflexes from taking over in stressful situations.

Your personality as a trader plays an important role here. This is because markets will hold up an unfiltered mirror to you and will lay bare your specific strengths and weaknesses. This is why having a good mix of strong personal characteristics and competencies is so important.

Every trader has individual talents for certain trading styles and market segments or niches. With a lot of practice, you can perfect your personal abilities. In this way, you'll become an expert in your particular niche. The trick is finding the right trading environment for your personality. (For more on how to determine your trader personality and trading style, see Chapter 3.)

Using psychological testing tools to identify your personality traits and determine your fields of competency helps you discover your special strengths and develop them in the most effective way. I can assure you that this method has helped many traders achieve real breakthroughs in their development.

This is why it’s in your hands — well, your head, to be exact — to create the prerequisites and the foundation for successful trading.

Expertise requires many years of hard work and a lot of practice. What sets successful traders apart is goal orientation, a strong will, a lifelong desire to learn, and a willingness to always develop further. The brain of a successful trader has developed and consolidated the corresponding neural circuits because, as you have now found out, trading is first and foremost a head thing, not a market thing.