Perhaps the most famous trading experiment ever was when commodities investor Richard Dennis bet his partner William Eckhardt in 1983 that he could form a group of hobbyists – nicknamed “the turtles” – to that they become successful futures traders.
The bet was to be settled by giving the turtles real money to trade. In the end, the Turtles compiled an impressive record, giving Dennis the win.
Although the experiment settled the question in the popular imagination, it lacked the transparency, controls and statistical rigor demanded by academics. So, since then, researchers have strived to understand trading success through various studies – efforts that have not gone unnoticed by firms trading financial assets.
The latest entry in this quest comes from the Federal Reserve Bank of New York in collaboration with researchers from the University of Southern California and University College London. For a paper titled “Strategic Sophistication and Trading Profits: An Experience with Professional Traders,” the authors recruited 56 professional traders, plus an equal-sized sample of college students for controls, and assessed their performance in a game computer-simulated trading. They then tested their subjects on a wide range of specific skills to see which skills correlated with business success.
The main finding was that among college students, the only useful predictor of business success was general intelligence. Among professional traders, however, neither intelligence nor other personality traits and cognitive skills mattered much. Success did not depend on any fundamental idea of value. What mattered was strategic sophistication in the sense of taking the analysis of the behavior of others to high levels.
This is reminiscent of the popular wisdom found in poker that “beginners think about their cards. With a little experience, they start thinking about the other player’s cards. Poker starts when you think what the other thinks of your cards.” The Fed document suggests that professional traders play poker, while students play games like chess, backgammon, or blackjack that depend on intelligence rather than guessing what other people are thinking.
Most people will classify this as a mildly interesting factoid. This is not surprising since we know that professional trading organizations use poker and other strategic games – like Wall Street firm’s Figgie, Jane Street – to screen and train traders. But the conclusion of the document goes far beyond the claim that the strategy is valuable for trading. This suggests that other things like intelligence, risk strategies, personality traits, or knowledge of fundamental value don’t matter – or at least are so evenly distributed among traders that they cannot be used to predict success.
Additionally, the paper, and many precedents in this area, contradict the result of the Turtle experiment which suggests that trading success is a matter of following certain rules, not something in the personality or mind of the trader. Conventional Wall Street wisdom is that there are prerequisite mental traits for successful trading, but there are many variations, not just one strategic skill.
Poker players sometimes make good traders, but not always. And chess players, backgammon players and all other expert players can succeed in different ways. Moreover, regardless of a person’s raw talent, success is believed to require a long learning curve. In contrast, the Fed paper found no benefit to years of education or experience or other trading metrics.
Who should you believe? The Turtle experiment and popular Wall Street wisdom have a great advantage, in that they are based on real people trading large sums of money in real financial markets. Unfortunately, this makes controlled experimentation prohibitively expensive. Formal studies and other academic work conducted under laboratory conditions make the results much more scientific, but at the cost of being a layer removed from reality. The Fed study uses a particularly sophisticated trading simulation, but it is still a simulation with relatively low stakes.
If you’re not a trader but want to be, whether for your own account or for an institution, the study suggests that you should play poker rather than attend classes and take course in game theory rather than economics. Conventional wisdom says that you should develop your comparative advantages, whatever they are, and study successful traders.
If your interest is in understanding the economic function of trading, the study suggests that it is a game that rewards the aggregation of information from other people’s bids and offers and the use of this information to provide liquidity. Conventional wisdom suggests that trading is a broader skill that combines fundamental and technical information to produce balance, with many different types of traders performing different functions.
Of course, this is just one study and won’t tip the scales in any direction. And his findings only suggest, not prove, broader implications. Still, if you like poker more than lectures and game theory more than economics, that’s good news. You may lose in business competitions with other students, but you have a bright future on Wall Street. On the other hand, if you rely on traders to assess fundamental economic value, the study is bad news. This suggests that they are focused on outdoing each other, not on investigating reality.
Whatever you think of the study and the possible implications, it is always good to see careful, controlled and rigorous analysis in an area where opinions tend to be much stronger than the grounds for those opinions. Hopefully, this will spark deeper thinking about trading – both how to do it better and what its role is in the economy – from people of all opinions.
Aaron Brown is a former Managing Director and Head of Capital Markets Research at AQR Capital Management. He is the author of “The Poker Face of Wall Street”. He may have an interest in the areas he writes about.
Disclaimer: This article first appeared on Bloomberg and is published by special syndication arrangement.
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