Every so often we read of a star trader who has lost so much money that he has given back all the profits he made in the previous few years and shaken his bank to its foundations. How on earth does this happen? Were the risk managers at the bank mistaken all along about this trader’s skill?
Maybe. But recent research in physiology and neuroscience suggests an alternative explanation — that the winning streak itself changed the trader. Human biology can today help explain the behavior that drives traders to acts of folly. At the heart of this research lies an important fact that is frequently overlooked: when we take risk, including financial risk, we do a lot more than think about it — we prepare for it physically. Body and brain fuse as a single functioning unit.
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Consider what happens when an important piece of news flashes across the wire. At that very instant, across the trading floor, traders’ senses are placed on high alert, allowing them to hear the faintest noise, see the slightest movement. Breathing accelerates, and they feel the thump of a heart gearing up for action. Muscles tense, stomachs knot and an imperceptible sheen of sweat creeps across their skin, anticipatory cooling for the expected activity. We do not regard information as a computer does, dispassionately. We register it physically.
This fusion of body and brain normally endows us with the fast reactions and gut feelings we need to survive in a brutal world, and a brutal market. My colleagues at the University of Cambridge and I have conducted a series of experiments on a trading floor in London and found that under circumstances of extraordinary opportunity otherwise known as a winning streak our biology can overreact, and our risk taking become pathological. A model from animal behavior, called the ‘winner effect’, provides an intriguingly illustration of how this can happen. When males enter a fight or competition their testosterone surges which increases their hemoglobin and hence their blood’s capacity to carry oxygen; and in the brain it increases confidence and appetite for risk. The winner emerges with even higher levels of testosterone and this heightens his chances of winning yet again, leading to a positive feedback loop. For athletes preparing to compete, traders buying risky assets, even politicians gearing up for an election, this is a moment of transformation, what the French in the Middle Ages called “the hour between dog and wolf.”
However, at some point in this upward spiral of testosterone and victory, judgment becomes impaired. Animals with highly elevated levels of testosterone end up starting more fights, neglecting parenting duties, and venturing into the open, all of which leads to increased predation. Effective risk-taking morphs into over-confidence and dangerous behavior and traders on a winning streak may take on positions of ever-increasing size, with ever worsening risk-reward trade-offs.
What happens to a trader’s biology if these positions blow up? Then their stress response goes into overdrive. The hormones adrenalin and cortisol order energy stores in liver, muscle, and fat cells to be broken down for immediate use; while long-term functions of the body, such as digestion, growth, reproduction, and after a while immune function, are inhibited. The uncertainty people feel during a crisis can raise stress hormone to such an extent that they promote feelings of anxiety, a selective recall of disturbing memories, and a tendency to find danger where none exists. Among traders and investors the stress response may foster an irrational risk-aversion, impairing their ability to manage positions put on in more optimistic times.
In short, traders’ biology may cause them to take too much risk when on a winning streak and then too little when the market needs it most during a crisis. Some traders may be more prone to this biological instability than others. After all, not all successful traders blow up. But risk managers at banks need to understand this biology—the statistical tools they rely on to give a snapshot of the firm’s positions cannot catch the subterranean shifts taking place in their traders’ risk appetite.
Risk managers could, however, learn from sports scientists how to spot and manage exuberance, fatigue and stress. They may have to manage their traders much as coaches manage their athletes. And that means occasionally pulling them off the field until their biology resets.