How Our Subconscious Impacts Our Trading Decisions

The conscious mind may be compared to a fountain playing in the sun and falling back into the great subterranean pool of subconscious from which it rises. -Sigmund Freud

The human brain weighs approximately 3.3 pounds and makes up just 2% of your body’s weight, yet takes up 20% of all energy consumed by your body and uses up more energy than any other organ. It is also unilaterally responsible for how you perceive, interpret, and react with the world. The brain can further be compartmentalized into areas which focus on conscious activity being driven by your five senses, which is how you are making sense of the external world, and the areas which produce all your subconscious thought, which is essentially everything that is on “autopilot”.

We, at RAIN, employ our own in house team of quantitative researchers, traders, and developers, and we are obsessed with finding ways to make more money in a quantitative fashion (we like to make it rain). And as stock market traders, we know that there is only so much that we can grapple with at any point in time. When the market opens each day, we are checking breaking news to see what is moving the markets. When the market closes, we need to square off all our intraday positions. Our code needs to not break, and if it does, we need to react swiftly under pressure and duress.

Oh, let’s not mention the fact that we’re also trying to make money during this whole process in a negative-sum market environment.

We, as human beings, tend to spend a lot of time thinking about what we are doing with our conscious state of mind. This, after all, seems practical, since our consciousness is really a function of what we are aware of at any point in time. We even go as far as to prime our minds in order to get us into the “right state of mind” by doing all the small things such as taking our vitamins, going to the gym, and getting enough sleep at night. For traders, we do all these things because we want to be in a great state of mind when making our investing and trading decisions.

But what’s really driving those decisions, in the first place?

Enter: The Almighty Subconscious Mind

Our sub-conscience is responsible for more than 90% of brain activity

When we delve deep into how we make our day to day decisions, especially the important ones, it becomes evident that the subconscious is much more at play than what appears on the surface. Researchers at Harvard and MIT have concluded that the brain is not only divided into two distinct areas — one which drives conscious thought, and the other which drives subconscious thought — but that the subconscious part of the brain is responsible for more than 90% of all decisions we make, and that figure could be closer to 95%.

It’s important to clearly understand what your subconscious is in order to understand its potential significance on your trading psyche.

In the best-selling book Thinking Fast and Slow, Daniel Kahneman bifurcates the decision making the process of the brain into “fast thinking” and “slow thinking” scenarios depending on the type of situation. When a situation is not presenting you with any surprises, your brain is in fast-think mode and is making decisions automatically/semi-automatically.

The fast-thinking brain is your subconscious at work, and it is also associated with intuition. When you’re driving a car, you’re not really thinking about where you’re driving, or how you’re driving — you’re just driving. Similarly, when you’re reading a financial newspaper, you’re not really slowing down and thinking about what you’re reading. You’re just reading.

At face value, this seems fine. What’s wrong with driving a car and reading a newspaper in a leisurely fashion? Nothing, of course — these activities are obviously perfectly fine in and of themselves. But that doesn’t discount the fact that, for example, experiencing road rage in the mornings leads to higher levels of stress. This increased level of stress, in turn, leads us to produce increased risk-taking, more impulsivity, and therefore greater likelihood of miscalculations and accidents, according to Stan Steindl, a clinical psychologist and adjunct associate professor at the University of Queensland.

That doesn’t sound very helpful towards making better trading and investing decisions when that is what you do for a living. Maybe you ought to start taking an Uber to work daily?

The Bottom Line

Cognitive bias is a real thing, and it impacts our lives in every single way, shape and form. The old school prevailing thought was that cognitive bias did not exist in finance. The basic idea was that human beings are perfectly rational by default and that all information is priced in, which lent to the popularity of “perfect environment” pricing theories such as the Efficient Market Hypothesis (EMH) and the Capital Asset Pricing Model (CAPM). But modern behavioral finance experts have disputed the validity of the EMH and CAPM, including the likes of Warren Buffett, who has successfully disputed the EMH both empirically and theoretically. And according to Kahneman (referred to earlier), imperfections in the stock markets occur due to cognitive biases such as overconfidence, overreaction, and other types of biases. These errors in cognitive thinking lead us to avoid certain situations (such as buying value stocks) due to our failed ability to correctly assess risk under different circumstances.

And so the bottom line is simple: don’t overestimate yourself, and using that line of thinking, don’t overestimate anybody. Just like you and me, all global financial markets are filled with irrational human beings, each thinking that he or she is in full control of his or her emotions, feelings, thoughts, and actions when in reality, nobody really knows what in the world he or she is doing.