The Biological Component of Behavioral Finance
Behavioral finance, which is often used to explain irrational moves in financial markets, emphasizes the importance of psychological influences on investor behavior. The work of researchers, including Nobel Prize winner Daniel Kahneman, has examined those influences to provide useful insights that help with better decision making. However, focusing on only the psychological drivers of irrational behavior may overlook important biological components that also destabilize financial markets.
Irrational decisions, loss aversion, and mispriced risk have been linked to hormones found in the human body. These chemical messengers coordinate fight, flight, mating, feeding, and the struggle for status, and they have an impact on growth, metabolism, immune function, mood — and perhaps most importantly — memory, cognition, and behavior. Two specific hormones, testosterone and cortisol, come out in force during the excesses of bull and bear markets.
John Coates, neuroscientist and author of The Hour Between Dog and Wolf, has suggested that biology played a major role in the 2008 global financial crisis, finding a “Jekyll-and-Hyde transformation” that male traders experience when under pressure. His work suggests that overly aggressive behavior, caused by elevated levels of testosterone during a bull market, leads to dangerous levels of risk in the financial system. Cortisol, a second hormone that Coates has found to be present during times of heightened uncertainty, can delay or weaken economic recoveries.
Coates’ 2010 study found that testosterone is associated with reward, noting that traders had significantly higher testosterone levels on days when they made an above-average profit. However, excessive testosterone can make traders impaired and overconfident, leading to increasingly poor decisions as their risk tolerance is affected while their skill levels remain unchanged.
In the same 2010 study, Coates found that elevated cortisol levels were connected to extreme risk aversion among traders. High cortisol levels can contribute to the risk aversion and “irrational pessimism” found among bankers and fund managers during financial crises, causing a paralysis that prevents them from effectively allocating risk capital. “Traders, risk managers, and central banks cannot hope to manage risk if they do not understand that the drivers of risk taking lurk deep in our bodies,” according to Coates.
One way to offset biological changes driven by hormones could be to encourage a balance of men and women in a broader range of ages to participate in the markets. In an opinion published in The New York Times, Coates observed that “Women and older men have a fraction of the testosterone of young men, so if more of them managed money, we could perhaps help to stabilize the markets.” The effects of cortisol and testosterone are also influenced by relationship status — a University of Chicago study examining gender-based differences in risk taking found that marriage had a dampening effect on hormonal responses to psychological stress.
Data generated by the growing number of fitness monitors and other user-tracking devices may be another way for money managers to counter the physical triggers that lead to irrational decision making. The idea of “The Quantified Self” is gaining popularity among data-driven enthusiasts carefully tracking their behavior and vital signs as they attempt to reach a state of maximum productivity. Their insights may discover new correlations between physical and mental states. As the physical changes accompanying excessive approaches to risk are identified, steps can be taken to prevent them.
A different solution might be for banks to encourage appropriate levels of risk taking by linking compensation to a trader’s individual Sharpe ratio. According to Coates, looking more closely at the risks assumed in order to generate returns can identify skilled performers and expose reckless traders taking excessive risks, regardless of whether they are influenced by physical or mental drivers.
At the the 68th CFA Institute Annual Conference in Frankfurt, John Coates will be discussing his work in greater detail. You can learn more at the conference website.
If you liked this post, don’t forget to subscribe to the Enterprising Investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©iStockPhoto.com/retrorocket