Hormones flood our bodies—and brains—at moments of stress. Does that make financial markets irrational?
When you take risks, you are reminded in the most insistent manner that you have a body. For risk, by its very nature, threatens to hurt you.
A driver speeding along a winding road, a surfer riding a monster wave as it crests over a coral reef, a soldier sprinting across no-man’s land—each of these people faces a high chance of injury, even death. And that very possibility sharpens the mind and calls forth an overwhelming biological reaction known as the “fight-or-flight” response. In fact, so sensitive is your body to the taking of risk that you can be caught up in this visceral turmoil even when death poses no immediate threat. Winston Churchill, a hardened military campaigner, recognised this power of non-lethal risk to grip us. When writing of his early years, he tells of a regimental polo match played in southern India that went to a tie-break in the final chukka: “Rarely have I seen such strained faces on both sides,” he recalled. “You would not have thought it was a game at all, but a matter of life and death. Far graver crises cause less keen emotion.”
Similar strong emotions and biological reactions can be triggered by another form of non-lethal risk: financial risk-taking. Professional traders, asset managers and investors rarely face death in their dealings; but the bets they place can threaten their job, house, marriage, reputation and social class. In this way money holds a special significance in our lives, so making and losing it can activate a powerful biological response.
This statement about biology and the financial markets may sound strange to ears accustomed to the teachings of economics. Economists tend to view the assessment of financial risk as a purely cognitive affair, requiring the calculation of asset returns, probabilities, and the optimal allocation of capital. But to this bloodless account of decision-making I want to add some biology. For recent advances in neuroscience and physiology have shown that when we take risks, including financial risks, we do a lot more than just think about it. We prepare for it physically.
To get an inkling of how this physiology works, let us take a brief look at the trading floor of a large investment bank, a high-stakes world where young bankers can step up or down a full social class in the space of a single bonus season, one year buying a ski chalet in Verbier, the next pulling their kids out of private school. So consider the following scenario, in which a trader grapples with unexpected volatility in the market, caused by a rumour that the US Federal Reserve may raise rates later that afternoon.
The trader we are going to follow, let’s call him Scott, has spent the morning assessing the rumour, weighing the economic data, and setting his position. Then, as 2.15pm approaches, the time when the Fed makes its announcement, trading on the screen dwindles. The floor goes quiet. Across the world traders have placed their bets, and now wait. Scott feels intellectually prepared. But the challenge he now faces is also a physical task, and to perform it successfully he requires fast reactions, and sufficient energy to support his efforts for the hours ahead when volatility spikes.
Consequently Scott’s body has also prepared for the event. His metabolism speeds up, ready to break down existing energy stores in liver, muscle and fat cells. Breathing accelerates, drawing in more oxygen, and his heart rate increases. His nervous system has begun to redistribute blood throughout his body, constricting blood flow to the gut, giving him the butterflies, and to the reproductive organs—since this is no time for sex—and shunting it to major muscle groups in the arms and thighs as well as to the lungs, heart and brain.
The Fed announcement will bring volatility, and a chance to make money. As the sheer potential for profit looms in his imagination, Scott feels an unmistakable surge of energy as steroid hormones begin to turbo-charge the big engines of his body. These hormones take time to kick in, but once synthesised by their respective glands, they begin to change almost every detail of Scott’s body and brain—his muscle mass, mood, even the memories he recalls. Steroids are powerful, dangerous chemicals, so their use is tightly regulated by law, by the International Olympic Committee, and by the hypothalamus, the brain’s “drug enforcement agency.” If steroid production is not turned off quickly it can transform us, body and mind.
Over the past couple of hours, Scott’s testosterone levels have been steadily climbing. This steroid hormone, naturally produced by the testes, primes him for the challenge ahead, just as it does athletes preparing to compete and animals steeling for a fight. Rising levels of testosterone increase Scott’s haemoglobin, and consequently his blood’s capacity to carry oxygen; it also increases his confidence and, crucially, his appetite for risk. For Scott this is a moment of transformation, what the French since the Middle Ages have called “the hour between dog and wolf.”
Another hormone, adrenaline, surges into his body, tapping into glucose deposits, mostly in the liver, and flushing them into the blood so that Scott has back-up fuel supplies to support him in whatever trouble his testosterone gets him into. A third hormone, the stress hormone cortisol, trickles out of the adrenal glands and travels to the brain, where it stimulates the release of dopamine, a chemical operating along neural circuits known as the pleasure pathways. Normally stress is a nasty experience. But at low levels it thrills. A non-threatening challenge like a sporting match or an exciting market releases cortisol, and in combination with dopamine, one of the most addictive drugs known to the human brain, it delivers a narcotic hit, a rush, a flow that convinces traders there is no other job in the world worth having.
Now, at 2.14pm, Scott leans into his screens, gaze steady, pupils dilated, muscles coiled, his breathing rhythmic and deep—body and brain fused for the impending action. An expectant hush descends on global markets.
The above scenario illustrates just how sensitive our bodies are to information, such as the Fed announcement. Information, mere words on a page or prices on a screen, provokes a strong bodily reaction. We do not regard information as a computer would, dispassionately; we react to it physically. The body and brain rev up and down together. Indeed, it is upon this simple piece of physiology that much of the entertainment industry is built: would we read novels or go to the movies if they did not take our bodies on a rollercoaster ride?
During the dotcom bubble, biology forced itself on my attention. I was at that time running a derivatives desk for Deutsche Bank in New York, and during this period traders and investors had succumbed to the euphoric and delusional behaviour that came to be called “irrational exuberance.” They had become overconfident in their risk-taking, placing bets of ever increasing size and with ever worsening risk-reward trade-offs.
Behaviour of this kind recurs in most bull markets, for as a rally starts to validate investors’ beliefs, the profits being made bring on powerful feelings of euphoria and omnipotence. Assessment of risk is replaced by judgements of certainty—traders just know what is going to happen. They even walk differently: more erect, more purposeful, their very bearing carrying a hint of danger. Tom Wolfe nailed this delusional behaviour when he described the stars of Wall Street as “Masters of the Universe.”
When traders enjoy an extended winning streak they experience a high that is powerfully narcotic, and very difficult to control. Any trader knows the feeling, and they all fear its consequences. Under its influence they tend to feel invincible, and to put on such stupid trades that they end up losing more money on them than they made on the winning streak that kindled this feeling of omnipotence in the first place. It has to be understood that traders on a roll are traders under the influence of a drug that has the power to transform them into different people.
And perhaps this chemical, whatever it is, accounts for much of the silliness and extreme behaviour that accompany bubbles, with people losing themselves in ill-fated delusions, mixed identities and swapped partners, until the cold light of dawn brings the world back into focus. After the dotcom bubble burst, traders were like revellers with a hangover, heads cradled in hands, stunned that they could have blown their savings on such ridiculous schemes. The shocked disbelief that the reality sustaining them for so long had turned out to be an illusion has nowhere been better described than on the front page of the New York Times the day after the Great Crash of 1929: “Wall St,” it reported, “was a street of vanished hopes, of curiously silent apprehension and a sort of paralysed hypnosis.”
I have a special reason for relating these stories of financial excess. I am not presenting them as items of front-line reportage, but rather as overlooked pieces of scientific data. Scientific research often begins with fieldwork. Fieldwork turns up curious phenomena or observations that prove to be anomalies for existing theories. And the behaviour I am describing constitutes precisely this sort of field data for economics. Yet it is rarely recognised as such. Indeed, of all the research devoted to explaining financial market instability, very little has involved looking at what happens physiologically to traders and investors when caught up in a bubble or a crash. This is an extraordinary omission, comparable to studying animal behaviour without looking at an animal in the wild. I am, however, convinced we should be looking at risk-takers’ biology. I think we have to take seriously the possibility that physiological changes brought on by profits and losses, and by volatility in the markets, can shift risk preferences systematically across the business cycle, destabilising the markets. And that conclusion could profoundly change how we see the markets and how we cure their pathologies.
Convinced we should be studying the ways in which the body affects financial decision-making, I returned to the University of Cambridge, where I had previously done a PhD. My colleagues and I then began a series of ongoing experiments on trading floors in the City and in a lab in Cambridge. These are designed to test the hypothesis that the molecule of irrational exuberance is in fact the steroid hormone testosterone; that rising levels of this hormone can morph prudent risk-taking into risky behaviour, and a bull market into a bubble.
My colleagues and I have also been collecting data suggesting that irrational pessimism may be a natural consequence of the stress response, a body-wide reaction to conditions of novelty, uncertainty, and uncontrollability, conditions that are found in extreme form during a financial crisis, such as the summer of 2008—or indeed 2012. Chronic stress in the markets, and in the workplace more generally, can promote an irrational risk-aversion. Worse, it can contribute to cardiovascular, metabolic, and immune-system disorders.
In time, as our research progressed, we looked beyond hormones to the influence of other physiological systems on a trader’s performance, especially the remarkable chemical and electrical circuitry carrying their so-called gut feelings. We have also been in touch with groups studying the same biology but applying it to different professions. David Owen, for example, a veteran politician and a trained neurologist, applying it to politics; and sports scientists applying it to their athletes.
What is emerging from this research is a picture of the universal biology of risk-taking, one shared by a politician winning a large majority, a tennis player rushing to the net, and a trader barrelling into sub-prime mortgages.
Economics has rarely looked at the influence of the body on financial decision-making, preferring to see risk-taking behaviour as a purely cognitive activity. It is economics from the neck up. Why has it so insistently ignored the body? The reason, I believe, is that we in the west have inherited a culture dominated by a Platonic notion of a mind-body split, according to which a human’s core competence and distinguishing faculty is pure thought.
But conscious, rational choice is just a bit player in the drama of our lives. Many economists do indeed recognise this. Behavioural economists, and lately economists studying neuroscience, have built a more robust model of financial risk-taking, with all its quirks. But this wonderful research needs to recognise more explicitly that the brain is inextricably linked with the body, that the two evolved together and work together as a single unit. This fusion of body and brain provides us with the fast reactions we need to survive in a brutal world, with the gut feelings upon which we rely for good decision making. In the words of Daniel Kahneman—a Nobel prize winner in economics, who has done extensive research into the physiology of attention and arousal—“we think with our bodies.”
The biology of risk-taking can, however, occasionally become unbalanced, and when it does, the markets suffer. If biological forces exaggerate bull and bear markets—and perhaps even destabilise our politics—then we have to think about how to alter training programmes, management practices, even policy in order to counteract it.
At the moment, though, I fear we have the worst of both worlds—an unstable biology coupled with risk-management practices that increased risk limits during the bubble and decreased them during the crash, plus a bonus scheme that continues to reward high-variance trading. Today nature and nurture conspire to create recurrent disasters. Risk managers need to dampen these biological waves, not amplify them.
To help them do so, economists need to conduct science in the workplace. We have to study risk-takers bearing heavy loads, and observe the consequences. There are admittedly barriers to doing so—conducting science is expensive, with individual experiments running into the hundreds of thousands of pounds, and gaining access to the workplace can prove difficult. But the rewards are potentially large. My impression is that the corporate world is starved for this research. What managers need is science conducted with the same concepts as the ones they use in their jobs. They warm to scientific research whose variables include, say, “P&L” (profit and loss) “VaR” (value at risk) or “Sharpe Ratio” (risk-adjusted P&L). Furthermore, they are reassured when they find that their insights into the behaviour of risk-takers can be advanced by research in biology and medicine. The 19th century physiologist Rudolf Virchow once said that politics is medicine writ large, and today we could say the same of economics.
An economist responds
Focus on frameworks, not people
John Coates’s thesis is challenging. The interesting issue for the political economist is whether, if participants in financial markets were driven by the factors he suggests, it would change our view of the role that free markets play in finance.
One of the straw men that has arisen in the last 20 years or so is the idea that free-market economists assume that human rationality is necessary for markets to function. Certainly, this assumption is useful for creating models in some fields of economics. However, free-market economists who take a broader perspective argue that a market economy is robust under a whole range of assumptions about human behaviour.
Some people may be cautious in the face of risk; others may be reckless; still others may be highly intuitive when they make decisions; and some may be rational calculators. In reality, decisions are determined by a mix of motivations. But, when deciding whether to intervene in markets, we should not be asking how people make decisions, but what institutional framework is most robust under a range of decision-making processes.
It is quite possible that traders and others working in finance are driven by the motivations suggested by Coates: feelings of euphoria and so on. If so, it is important that such people feel the full cost of their irrational decision-making and it is also important that providers of capital to financial institutions ensure that top management restrains reckless behaviour. Finally, we should ensure that central banks do not fuel asset-price booms with loose monetary policy.
We cannot assume that regulators can impose rationality. Much more effective is a world in which people take responsibility for their own recklessness. Such an environment will help tame behaviour and reduce the attractiveness of jobs in financial markets to hormone-driven risk takers. Perhaps this is why, in the late-19th century, there was such a preponderance of people with a conservative disposition in financial markets. Today, on the other hand, the institutional mechanisms that kept tabs on risk-taking have been eroded, as losses are underwritten by governments and central banks have the equivalent of a pub with free beer for alcoholics.
Philip Booth is programme director at the Institute of Economic Affairs and professor of insurance and risk management at Cass Business School
A philosopher responds
Mind cannot be reduced to body
John Coates’s argument raises two broad philosophical points. First, he traces economists’ reliance on rational choice theory (the view that individuals always make decisions that they believe will maximise their self-interest) to a sharp distinction between mind and brain. But the father of rational choice was the 17th-century philosopher Thomas Hobbes, a physicalist who rejected this distinction. As such he would have likely welcomed Coates’s behavioural-physiological account. Rational choice theory as a general account of reason was always a non-starter, and shouldn’t be attributed to deep-seated metaphysical commitments.
Second, Coates warns against those who think of body and mind as two different things, but he himself skirts a false reductivism. True, we have a body with organs (brains), processes (blood circulation), hormones, and more. But we also have a mind. A mind is neither reducible to brain states, nor to neural networks, nor to “the software of the brain,” nor to some “mental” substance. Our mind consists of a vast array of cognitive and cogitative powers: abilities to give and respond to reasons, imagine alternatives—and assess risks. (The very premise of Coates’s study depends on an accurate assessment of risks, otherwise—even in hindsight—we wouldn’t know if assessments were rational or irrational, smart or stupid.)
If our brains are damaged, then of course our mental powers are diminished or destroyed. Our mental powers, however, are not lone motivating factors except in extreme situations (eg an LSD trip). “My hormones made me do it” is never an excuse and only a partial explanation. For although one’s judgement might be impaired in situations like the one Coates describes, it isn’t just along for the ride, either. (Compare with drinking and driving: the logic is the same.)
So, first, I would caution against thinking reductively about mind/brain and, second, suggest that it matters when and if one’s rational powers are “in charge” and when they are distorted. I conclude by applauding Coates’s use of behavioural economics coupled with studies of how hormones distort judgement, and hope that he will explore the normative implications—but avoid tempting philosophical dead ends concerning mind and brain.
Hans Oberdiek is a professor of philosophy at Swarthmore College, Pennsylvania
A neuroscientist responds
Difficult to test the theory
John Coates’s ideas are speculative, but they ought to be considered seriously. The main obstacle to testing and verifying the thesis is the almost unimaginable complexity of the brain-body-environment-behavioural system in question.
Take the human brain. It has roughly 100 billion neurons, each capable of 1000 connections—that’s a network of 100 trillion interactions. Multiplying the complexity further are the signalling chemicals which mediate the flow of information in the neuronal networks. These include the hormone and transmitter molecules mentioned by Coates, but there are many more and the role of most in human behaviour is unknown.
Studying their role in decision-making is a very active area of research in neuroscience but the task is hugely challenging. The scale of the problem is illustrated by our attempt to analyse decision-making in a simple model consisting of just 100 neurons or so, in contrast to the billions of the human brain. Even in this mini-network, we do not yet know how decisions are made.
Causal interactions within the brain and body are not just complex but also predominantly non-linear. This means that prediction of future behaviour based on the prior state of the brain’s chemistry is not just difficult but may be impossible. We can measure with considerable precision the fluctuating concentrations of a variety of signalling molecules in the brain, but we lack the analytical tools to predict with any certainty their outcome in terms of behaviour. Nevertheless, the quest for causality is central to many fields that deal with complex systems—weather forecasting, for example.
It’s interesting to note that a statistical tool called Granger Causality (G-causality), successfully applied to economic forecasting since the 1960s, is today being applied in neuroscience to the analysis of electrical brain activity. Unfortunately, the mathematical formulation developed by Clive Granger works well for predictive modelling of linear systems but has more difficulty dealing with non-linearity. That said, G-causality might be a helpful tool in experimental tests of Coates’s ideas.
However, at present, experimental tests remain a problem for Coates’s theories. Indeed in the form presented in the essay, these ideas are interesting but not, strictly speaking, scientific, because I cannot see how they could be refuted experimentally. At present, at least, Coates’s theories run ahead of what we can know for certain about the neuroscience of action. However, his emphasis on the dominant role of testosterone in the irrational behaviour of men suggests one experiment that might be worth trialling. Why not monitor the long-term consequences on financial stability of firing all male bankers and traders and replacing them with women?
Michael O’Shea is a professor of neuroscience at the University of Sussex