By JOHN COATES
Cambridge, England
WHAT happens to your body when you take risks? What happens to it when you make or lose money? Economics rarely asks these questions. It tends to view the assessment of financial risk as a purely intellectual affair, involving the calculation of asset returns, probabilities and allocation of capital. It is economics from the neck up.
But to this bloodless account of decision making, I want to add some guts. Advances in neuroscience and physiology have shown that when we take risk, we do a lot more than just think about it. We prepare for it physically.
Normally, the body of a risk-taker purrs along efficiently — after all, our bodies have been crafted for the quick reactions and gut feelings we need to survive in a brutal world. But not always. Under circumstances of outrageous success or terrifying failure, our biology can overreact; and when this happens to traders and investors, they suffer an irrational exuberance or pessimism that can destabilize financial markets and wreak havoc on the wider economy.
To get an inkling of how this physiology works, consider the following scenario, in which a trader grapples with a rumor that the Fed may raise rates later that afternoon:
As 2:15 — the time of the announcement — approaches, trading on the screens dwindles. The floor goes quiet. The trader feels intellectually prepared. But the challenge he faces requires more than cognitive skill. He needs fast reactions, and energy for the hours ahead.
Consequently, his metabolism speeds up, ready to break down energy stores in liver, muscle and fat cells. Breathing accelerates, drawing in more oxygen, and his heart rate speeds up. Cells of the immune system take up position at vulnerable points of the body, ready to deal with injury and infection. And his nervous system, extending from the brain down into the abdomen, redistributes blood — constricting flow to the gut, giving him butterflies, and to the reproductive organs, since this is no time for sex — shunting it to major muscle groups in the arms and thighs as well as to the lungs, heart and brain.
The announcement will bring volatility, and a chance to make money. The trader feels a surge of energy as steroid hormones are synthesized by their respective glands and injected into his bloodstream. Steroids are powerful, dangerous chemicals — they change almost every detail of body and brain: his growth rate, lean-muscle mass, mood, even the memories he recalls — and for that reason their use is tightly regulated by the International Olympic Committee and the hypothalamus, the brain’s drug enforcement agency.
These past hours, the trader’s testosterone levels have been climbing. This steroid hormone, produced by men (and, in lesser quantities, by women) primes the trader for the challenge ahead, just as it does athletes preparing to compete and male animals to fight. Rising levels increase confidence and, crucially, appetite for risk. For the trader this is a moment of transformation, what the French since the Middle Ages have called “the hour between dog and wolf.”
The stress hormones adrenaline and cortisol surge out of the adrenal glands, and the cortisol travels to the brain, where it stimulates the release of dopamine, a chemical operating along neural circuits known as the pleasure pathways. At high levels, cortisol provides a nasty, stressful experience. But in small amounts, in combination with dopamine — one of the most addictive drugs known to the human brain — it delivers a narcotic hit, a rush that convinces traders that there is no other job in the world.
Finally, at 2:14, the trader leans into his screen, pupils dilated, breathing rhythmic, muscles coiled, body and brain fused for impending action. An expectant hush descends on global markets.
This scenario illustrates just how sensitive the body is to information. We do not regard prices on a screen as a computer would, dispassionately; we react physically. Our body and brain rev up and down together, and this natural fusion makes us better risk-takers.
WHEN I was running a derivatives desk for Deutsche Bank during the dot-com bubble, however, I began noticing pathologies in this biology. Traders, normally a prudent lot, were becoming overconfident, placing bets of increasing size, with ever worsening risk-reward trade-offs.
As profits mounted, traders and investors seemed to feel the bonds of terrestrial life slip from their shoulders. Assessment of risk was replaced by judgments of certainty — they just knew what was going to happen. Extreme sports seemed like child’s play; sex became a competitive activity. They even walked differently. “I can handle anything,” their bodies seemed to say. Tom Wolfe nailed this euphoric and delusional behavior when he described the stars of Wall Street as Masters of the Universe.
I’ve not only observed this behavior. When I enjoyed a prolonged winning streak and expected a large bonus, I, too, became the picture of cockiness. Frankly, I cringe when I think about it.
The point I want to make, though, is this: The hubris that traders experience during a bubble can be as overwhelming as passionate desire or wall-banging anger. They are under the influence of some naturally produced narcotic, one that can transform them into different people. I have come to think of it as the “molecule of irrational exuberance,” and to take seriously the possibility that during bubbles — and crashes — the financial community turns into a clinical population.
Convinced we should be looking at the influence of the body on risk-taking, I made the decision — frequently regretted — of retiring from Wall Street, going to Cambridge University and retraining in physiology and neuroscience. My colleagues and I set up a series of experiments to test the hypothesis that the molecule of irrational exuberance was in fact testosterone — that levels of this hormone rise with above-average profits, increase risk-taking and morph prudent decisions into risky ones.
In one experiment we sampled hormones from 17 male traders and found that their testosterone did indeed rise with above-average profits, and in other studies, with 54 traders, we found that higher testosterone led to greater risk-taking. These experiments are continuing, but the preliminary data was strong enough to be published by the National Academy of Sciences. We collected equally powerful data suggesting that the molecule of irrational pessimism — which we suspect can promote chronic risk aversion, driving a bear market into a crash — is the stress hormone cortisol.
Understanding the effects of human biology on the markets should profoundly change how we see them, and their pathologies. At the moment, I fear we have the worst of both worlds — an unstable biology coupled with policies that encourage too much risk-taking during bubbles and too little during crashes, as well as a bonus scheme that penalizes prudent risk-taking. Nature and nurture conspire to create recurrent disasters. Risk management needs to dampen these biological waves, not amplify them.
One way to do that would be to encourage a more even balance within banks among men and women, young and old. Women and older men have a fraction of the testosterone of young men, so if more of them managed money, we could perhaps stabilize the markets. We could also look to sports scientists for guidance, for they are the ones with the most skill at managing biology in the interests of performance, at developing a resilience to exuberance, fatigue and stress.
Finally, we should recognize, on a personal level, that “know thyself” means know your biochemistry.
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