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Risk, Trading & Human Psychology - Part II

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The Agricultural Producer

As we discussed in Part I, human nature often seems to work counter to making good trading and risk management decisions.  While a great deal of effort has been made to encourage agricultural producers to proactively manage their commodity price risk, in practice risk management often fails to live up to expectations, particularly when it comes to the human dimensions.  The good news is that recent discoveries in the field of neuroeconomics are starting to provide some powerful insights into what drives trading and investing behaviour, along with the promise that this knowledge can be translated into superior trading and risk management decisions.

Neuroeconomics is an interdisciplinary fusion of economics, psychology and neuroscience (the science of the brain) that seeks to explain human decision making and economic behaviour.  Having worked as a commodity risk practitioner for the past 20+ years, it is fascinating to see the “light bulbs going on” as I learn about many of the breakthroughs in neuroeconomics and relate them to my own experience. 

The purpose of this article is to begin to apply some of the concepts and insights from the field of neuroeconomics to the risk management challenges of an agricultural producer.  While it may seem like a big stretch to go from farming to neuroscience, I believe there are some powerful linkages. 

To begin, I would argue that agricultural producers are particularly prone to the psychological and emotional pitfalls associated with trading and risk management.  As I have discussed in previous articles, risk management objectives and strategies are more difficult to define for natural longs (producers) and natural shorts (end users) than for merchandisers in the middle of the value chain.  This is illustrated in Figure 1. 

Merchandisers tend to be margin-focused and have discrete moments when they buy and sell cash commodities, against which offsetting hedges can be placed.  However, for natural longs (such as agricultural producers) and natural shorts, their price risk is more continuous in nature and develops in a more ambiguous fashion.  For example, does a farmer get long wheat when they plant the crop or when it is harvested?  What about next year’s wheat crop that they intend to plant?

There are a number of other factors that impact the psychological and emotional aspects of managing price risk for a field crop producer.  First, the magnitude of the commodity price risk faced by a field crop producer is very high relative to their overall profit margin. The price of the crop typically overwhelms everything else in the operation.  Second, the frequency of pricing tends to be fairly low, thus each pricing and risk management decision can have a large impact on the overall financial performance of the farm.  Third, farmers have reasonably limited ability to adjust output once a crop has been planted, other than through the application of inputs.  Finally, there is a relatively low degree of diversification across commodities as farms concentrate on a limited number of crops and are further constrained by rotational considerations.  I believe that all of these factors increase the significance of individual pricing and risk management decisions and tend to accentuate the associated psychological and emotional factors at play.

While the field of neuroeconomics involves a dizzying array of topics and themes, for our purposes we can distill it down to the idea that there are three basic influences on risk perceptions, attitudes and economic decision making.  These three influences are reason, heuristics and emotion.  This framework is illustrated in Figure 2 and is based largely on the ideas and terminology from “Your Money & Your Brain” by Jason Zweig and “Understanding and Managing Risk Attitude”, by David Hillson and Ruth Murray-Webster. 

Reason & the Reflective Brain:  The first influence is reason, or what Zweig refers to as our “reflective” system.  This involves the analytical part of the brain that is used for solving complex problems and making what economists would refer to as rational economic choices.  Now you might already be thinking that the best decisions about risk would be made if we could somehow eliminate the emotional and psychological influences and concentrate on pure reason.  In fact, the research suggests that people that rely too heavily on their analytical or reflective systems often make very poor traders and end up “losing the forest for the trees”.  This confirms my long held belief that fundamental market analysts and academics often make the worst traders.  Because our brains can’t possibly analyze all of the information we are presented with each day, the reflective system prefers not to kick in unless it has to and defaults to the reflexive system most of the time. 

Heuristics & the Reflexive Brain:  Heuristics refer to the short cuts that our brains use to process information and make the thousands of decisions we are faced with each day.  Zweig refers to this as the reflexive or intuitive part of our brain.  The interesting thing about heuristics and the workings of the reflexive brain is that it operates at a subconscious level and we are normally not aware of the processes our brains are using to make economic decisions. 

One of the major themes of neuroeconomics is that our brains have evolved in a manner that is suited to a very different type of decision making than we typically encounter when making modern day economic and risk-related decisions.  Our brains are ideally wired for basic survival skills, such as recognizing simple patterns and generating lightning-fast emotional responses, but are not so good at discerning long term trends, recognizing randomness and evaluating multiple factors. 

So let’s take a brief look at three heuristics related to risk and see how they might apply to an agricultural producer.  

Pattern Recognition and Ambiguity Aversion
According to neuroeconomists (not sure that is really a word yet), the human brain has an insatiable desire to recognize patterns and identify causal relationships.  As Zweig puts it “just as nature abhors a vacuum, people hate randomness”.  This is clearly evident in modern day markets, where an enormous amount of effort goes into analyzing markets and predicting prices.  The pattern recognition heuristic suggests that our brains are highly prone to perceiving patterns and relationships that do not exist in reality.  This is a red flag for agricultural producers that may be over-relying on their “view of the market” when making pricing and risk management decisions. 

Closely related to this I believe is the concept of ambiguity aversion.  Much research has demonstrated that people are averse to ambiguity and will normally prefer a more certain outcome to an ambiguous outcome, even though the expected payoff may be lower.  Thus, we have a tremendous desire to make sense of the market and a strong compulsion to make price predictions, based on a very small set of publicly available information and rather strong evidence as to the random nature of most markets.  I have long felt that many agricultural producers focus too much of their marketing and risk management process on price forecasting.

Confirmation Bias
Confirmation bias is another heuristic the brain uses to make decisions.  Confirmation bias occurs when we make an assumption based on limited information and then look for evidence to support or refute our assumption.  However, once we have made our assumption or formed a theory, the brain tends to seek out evidence to support it and has an amazing ability to ignore evidence to the contrary.  In his book “The Black Swan” Nassim Nicholas Taleb talks about ideas being “sticky” in that once we produce a theory in our mind, we are not likely to change it.  This is very common in markets, where a trader or analyst will develop a view of the market and then look for evidence to support their view.  With the huge amount of data available today, this is usually quite easy to do.  The result, however, can be over-reliance on a viewpoint or price forecast that has no basis in fact.  As Taleb says, sometimes information is bad for knowledge!

Anchoring and Adjustment
Another heuristic that has many economic applications is anchoring.  When asked to provide a forecast of something, the brain looks for an anchor or reference point as a means of reducing the field of possibilities, and then makes an adjustment up or down.  This is so powerful that even a seeded number that has nothing to do with the problem at hand can influence a person’s estimate or perception of value.  In markets, one of the logical anchors or reference points that our brains no doubt use is past prices.  Imagine a corn producer looking at new crop corn futures around $6/bushel during the summer of 2013.  Based on the long term price history, this was a phenomenal price for corn, however, one has to wonder how much of an anchoring effect the $7 to $8/bushel prices from the previous year had on risk management decisions (the price ended up closer to $4/bu incidentally).
There are many other heuristics that relate to pricing and risk management decisions made by agricultural producers.  There is also a range of so-called “group heuristics” that are relevant to risk management decisions being made in a group setting, such as the groupthink heuristic, the Moses factor, the risk shift heuristic and the cautious shift heuristic.

Emotion:  The third basic influence on risk perception, attitudes and decisions is emotion.  The field of neuroeconomics has helped bring to light the powerful impact of emotions when it comes to activities that involve making and losing money.  Using MRI imaging of the brain, it has been shown that the activity in the brain when a person is making money is virtually indistinguishable from that of someone who is high on cocaine or morphine.  Conversely, financial losses are processed in the same areas of the brain that respond to mortal danger.  Trading and risk management decisions therefore stir up some of the most profound emotions that a person can experience.  But emotions are not all bad, as one of the main functions of emotions is to steer a person away from a risky choice. 

While we will leave a more thorough discussion about the impact of emotions on trading and risk management decisions for another article, suffice to say that the research clearly shows that emotion can significantly alter economic decisions and risk taking behaviour.  At its most basic level, positive emotions can lead to overconfidence and “highs” that result in excessive risk taking behaviour.  Conversely, negative emotions can result in excessive risk aversion and missing out on opportunities with very attractive risk/return profiles.  Another interesting one is that we tend to be more risk seeking in the “loss domain” (i.e., when we are losing money) and more risk averse in the “gain domain” (i.e., when we are making money) and that stress (emotion) tends to exaggerate this tendency.  Ring any bells with you?

Thus far, the evidence from neuroeconomics suggests that a balance between reason (the reflective system) and intuition (the reflexive system), combined with a healthy control over one’s emotions is the best recipe for good economic decision making, which I believe translates very nicely over to commodity trading and risk management decisions.  In my experience, simply the awareness of what factors are at play subconsciously and emotionally helps enormously in understanding what it takes to effectively manage commodity price risk. 

Ron R. Gibson

In all its messy, miraculous complexity, your brain is at its best and worst – and most profoundly human – when you make decisions about money.

 - Jason Zweig

 

Gibson Capital Inc.
Calgary, Alberta, Canada

Email: info@gibsoncapital.ca


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