There is a tendency in economics to think that financial risk-taking is a purely cognitive activity. But as Dr John Coates explains, it’s more quirky than that.
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Young male city traders on a winning streak shift their risk preferences and take on too much risk. When they lose money in a volatile market, their hormonal response drives the financial community to being risk averse.
Dr John Coates, now a Senior Research Fellow in Neuroscience and Finance at Cambridge Judge Business School, turned his back on Wall Street as a Derivatives Trader to investigate the changes he says he felt in himself and noticed in colleagues, when making above average profits or above average losses.
“There’s a tendency in economics to think that financial risk-taking is a purely cognitive activity. Then rational ‘behavioural economics’ came along and said it’s more quirky than that.
“We’ve been trying to identify the molecules and nervous pathways in the body that contribute to this transformation, that would account for shifts in risk preferences which we think destabilise the financial markets.”
His book The Hour between Dog and Wolf: Risk Taking, Gut Feelings and the Biology of Boom and Bust is underpinned by research in Cambridge and London into the body’s reaction when risks are taken.
Dr Coates says that tried and tested research pointed the finger towards the ‘molecule of irrational exuberance’ – the chemical that causes traders, during a bubble or a winning streak, to take too much risk.
Robust animal behaviour model the ‘winner effect’ was applied, and research showed that rising levels of testosterone drove that animal to take more risks, become more confident, increase its haemoglobin and therefore step up oxygen content in the blood.
The ‘winner effect’ was known to exist in humans – athletes and it was identified in city traders, says Dr Coates.
“We have got really good preliminary data to suggest that rising levels of testosterone in young male traders, when they are on a winning streak are actually shifting their risk preferences and causing them to take too much risk.”
Dr Coates insists an even more interesting finding came from the response to stress the financial world.
“When the volatility of the market picks up, when traders are losing money, when the volatility of their profits and loss increases, the stress response in their bodies kicks in. That has an incredibly powerful effect on both on the body and brain. We think that it causes risk preferences to shift in the other direction so that it causes the financial community to become risk-averse just when you don’t want it to; that is during a crash.
“We think that these two physiological reactions to above-average opportunity or threats are shifting risk preferences and not causing financial market instability so much as exaggerating it.”
Dr John Coates is a Senior Research Fellow in Neuroscience & Finance at Cambridge Judge Business School.