trading finance Chicago Mercantile

The Hour Between Dog and Wolf

While computers may be the backbone of modern investment infrastructure, they can sometimes make a spectacular mess of things. Take the 2010 flash crash, when failures in computer trading systems across the country caused stocks to plunge 10% in a matter of minutes. Events such as this can make investors pine for the rock solid instincts of an experienced broker.

 

Investors like to think their decisions are driven by reason, research and logic, but according to Cambridge University neuroscientist John Coates, they’re also shaped by biochemical reactions.

 

Coates has combined his unique experience in finance — for years he headed a derivativesdesk in New York – with his PhD in neuroscience to defend this bold theory, which he outlines in his book The Hour Between Dog and Wolf: Risk Taking, Gut Feelings and the Biology of Boom and Bust.

 

Much of Coates’ book hinges on the idea that biology, and not just pure reason, drives many of our actions. When it comes to finance, he argues that steroid hormones like testosterone and cortisol also help shape bull and bear markets.

 

Coates bases his theory on studies of the physiological changes that occur when young male traders in London are put in competitive situations, where risk-taking holds the potential for larger rewards. A simple burst of testosterone can help traders make timely and profitable decisions, but when too much testosterone comes into play, overconfident traders tend to take riskier positions, which increase their chance of eventually entering a losing trade. When they do find themselves on the losing end of a trade, cortisol – also known as the anti- testosterone – kicks in.

 

If cortisol remains in the body for too long, traders may become excessively gloomy and risk-averse, lowering their ability to enter a profitable trade. “During a severe bear market, the banking and investment community may rapidly develop into a clinical population,” Coates writes.

 

Coates’ theory may seem simplistic, but he does an admirable job of backing up his arguments with explanations from biochemistry and neurobiology. In doing so, he breaks down the notion of risk into its most basic biological components: cortisol and testosterone.

 

Coates says trading floors could benefit from having greater “testosterone diversity” by, among other things, hiring more women, who typically have 10% to 20% the testosterone levels of men. He further proposes hiring financial professionals entering middle age, as their testosterone levels tend to decline.

 

Undoubtedly, Coates’ work will be controversial. However, he has a knack for taking neuroscience out of the lab and onto the trading floor, and provides unique insight into why human exuberance can sometimes be irrational.

 

Photo: Baron Visuals – Flickr