I have long been fascinated by the complex nature of the human mind, and the factors that influence the way we behave. Having chosen to study Psychology at A level, and then for my University degree, I recall reading, discussing and having to remember for my exams a huge range of studies; from the simple to the complex, which sought to examine behaviour patterns and explain the reasons behind such behaviour.
Last week’s Friday blog looked at the importance of human intuition in calculating risk, a topic much in vogue since 2008. Another of the greatest debates in psychology is between “Nature” and “Nurture”. At the extreme ends, those within the “Nature” camp believe that personality traits and behaviours are down to genetic factors which cannot be influenced by the social environment. Those within the “Nurture” camp believe our personality and behaviour is a function of the social environment to which we have been exposed. For example, does a child score well in a maths test because his/her parents were good at maths, or because he/she is taught by the best maths teacher? Nature say the former, Nurture the latter.
Often neither school of thought can prove conclusively that their theory is the only correct one. It’s most likely that the answer comes down to a combination of both. As science develops however, the evidence supporting the influence of genetic and biological factors is becoming more and more compelling.
It is because of this curiosity I was interested to read reviews (largely very positive) of a new book entitled The Hour Between Dog and Wolf, written by John Coates, former Wall Street trader and now current Neuroscientist at Cambridge University.
His work suggests that hormones drive investment decisions to a far greater extent than economists or bank executives realise. Could excessive risk taking, boom and bust nature of high finance be explained by biological factors? Coates suggests yes.
Coates calls testosterone “the molecule of irrational exuberance”. During moments of competition, risk-taking and triumph testosterone is released into the body in large quantities. In animals this leads to something called the “winner effect”. A male that wins one battle goes into the next one primed with higher levels of testosterone, helping him to win again. Eventually, though, confidence becomes cockiness. The animal starts more fights and experiences higher rates of mortality. According to Coates, when traders are on a winning streak, their testosterone levels surge, sparking such euphoria that they underestimate risk and display a similar “winner effect”.
Mr Coates thinks the exuberance that turns a market rally into a bubble may also be fuelled by the same chemical. In one experiment Mr Coates sampled testosterone levels in traders in London and found that higher levels of the hormone in the morning correlated with greater profits in the afternoon. Such profits came from taking higher risks, not greater skill.
Biology may also be responsible for worsening market sentiment in bad times. The body’s response to prolonged periods of stress is to secrete increasing amounts of cortisol. In a study on the trading floor, Mr Coates saw cortisol levels in traders’ saliva jump by as much as 500% in a day. Mr Coates found that cortisol levels in traders’ bodies fluctuate in line with market volatility, even displaying a striking correlation with the prices of derivatives.
A burst of chemicals can however be helpful for traders. Good traders seem to produce a lot of hormones, but only for short periods of time. Sustained periods of high levels of cortisone can eventually infringe investors’ ability to think rationally, allowing emotional responses to gain the upper hand. As a result, risk aversion grows as testosterone production is suppressed. “During a severe bear market,” writes Mr Coates, “the banking and investment community may rapidly develop into a clinical population.”
Before you think this cycle all sounds a bit depressing and unbreakable Coates offers a solution, and an interesting one at that. Women, who make up just five per cent of the trading floor, also produce testosterone but only a tenth as much as men. This has led Coates to suggest that hiring more women, and older men (who also have lower testosterone levels) and decreasing the number of testosterone charged young alpha males might over the years produce better results. Competitive situations do not activate women’s cortisol response with such intensity, so market mayhem is less likely to impair their judgment. Coates also argues that prudent risk taking would be more encouraged by a bonus scheme that pays traders well into a business cycle of four to five years, rather than once a year as it is currently.