The Hour Between Dog and Wolf: Risk-taking, Gut Feelings and the Biology of Boom and Bust. John Coates
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glucose now! At this crucial moment in your life, cortisol has in effect ordered a complete retooling of your body’s factories, away from leisure and consumption goods to war matériel.
In the brain, cortisol, like testosterone, initially has the beneficial effects of increasing arousal and sharpening attention, even promoting a slight thrill from the challenge, but as levels of the hormone rise and stay elevated, it comes to have opposite effects – the difference between short-term and long-term exposure to a hormone is an important distinction we will look at in this book – promoting feelings of anxiety, a selective recall of disturbing memories, and a tendency to find danger where none exists. Chronic stress and highly elevated stress hormones among traders and asset managers may thus foster a thorough and perhaps irrational risk-aversion.
The research I encountered on steroid hormones thus suggested to me the following hypothesis: testosterone, as predicted by the winner effect, is likely to rise in a bull market, increase risk-taking, and exaggerate the rally, morphing it into a bubble. Cortisol, on the other hand, is likely to rise in a bear market, make traders dramatically and perhaps irrationally risk-averse, and exaggerate the sell-off, morphing it into a crash. Steroid hormones building up in the bodies of traders and investors may thus shift risk preferences systematically across the business cycle, destabilising it.
If this hypothesis of steroid feedback loops is correct, then to understand how financial markets function we need to draw on more than economics and psychology; we need to draw as well on medical research. We need to take seriously the possibility that during bubbles and crashes the financial community, suffering from chronically elevated steroid levels, may develop into a clinical population. And that possibility profoundly changes the way we see the markets, and the way we think about curing their pathologies.
In time, and with the encouragement of several colleagues, I concluded that this hypothesis should be tested. So I retired from Wall Street and returned to the University of Cambridge, where I had previously completed a Ph.D in economics. I spent the next four years retraining in neuroscience and endocrinology, and began designing an experimental protocol to test the hypothesis that the winner effect exists in the financial markets. I then set up a series of studies on a trading floor in the City of London. The results from these experiments provided solid preliminary data supporting the hypothesis that hormones, and signals from the body more generally, influence the risk-taking of traders. We will look at these results later in the book.
MIND AND BODY IN THE FINANCIAL MARKETS
Research on body–brain feedback, even within physiology and neuroscience, is relatively new, and has made only limited inroads into economics. Why is this? Why have we for so long ignored the fact that we have bodies, and that our bodies affect the way we think?
The most likely reason is that our thinking about the mind, the brain and behaviour has been moulded by a powerful philosophical idea we inherited from our culture – that of a categorical divide between mind and body. This ancient notion runs deep in the Western tradition, channelling the riverbed along which all discussion of mind and body has flowed for almost 2,500 years. It originated with the philosopher Pythagoras, who needed the idea of an immortal soul for his doctrine of reincarnation, but the idea of a mind–body split was cast in its most durable form by Plato, who claimed that within our decaying flesh there flickers a spark of divinity, this being an eternal and rational soul. The idea was subsequently taken up by St Paul and enthroned as Christian dogma. It was by that very edict also enthroned as a philosophical conundrum later known as the mind–body problem; and later physicists such as René Descartes, a devout Catholic and committed scientist, wrestled with the problem of how this disembodied mind could interact with a physical body, eventually coming up with the memorable image of a ghost in the machine, watching and giving orders.
Today Platonic dualism, as the doctrine is called, is widely disputed within philosophy and mostly ignored in neuroscience. But there is one unlikely place where a vision of the rational mind as pure as anything contemplated by Plato or Descartes still lingers – and that is in economics.
Many economists, or at any rate those adhering to a widely adopted approach known as neo-classical economics, assume our behaviour is volitional – in other words, we choose our course of behaviour after thinking it through – and guided by a rational mind. According to this school of thought, we are walking computers who can calculate the rewards of each course of action open to us at any given moment, and weight these rewards by the probability of their occurrence. Behind every decision to eat sushi or pasta, to work in aeronautics or banking, to invest in General Electric or Treasury bonds, there purr the optimising calculations of a mainframe computer.
The economists making these claims recognise that most people regularly fall short of this ideal, but justify their austere assumption of rationality by claiming that people behave, on average, ‘as if’ they had performed the actual calculations. These economists also claim that any irrationality we display in our personal lives tends to fall away when we have to deal with something as important as money; for then we are at our most cunning, and come pretty close to behaving as predicted by their models. Besides, they add, if we do not act rationally with our money we will be driven to bankruptcy, leaving the market in the hands of the truly rational. That means economists can continue studying the market with an underlying assumption of rationality.
This economic model is ingenious, at moments quite beautiful, and for good reason has wielded enormous influence on generations of economists, central bankers and policy-makers. Yet despite its elegance, neo-classical economics has come under increasing criticism from experimentally-minded social scientists who have patiently catalogued the myriad ways in which decisions and behaviours of both amateur and professional investors stray from the axioms of rational choice. One reason for its lack of realism is, I believe, that neo-classical economics shares a fundamental assumption with Platonism – that economics should focus on the mind and the thoughts of a purely rational person. Consequently, neo-classical economics has largely ignored the body. It is economics from the neck up.
What I am saying is that something very like the Platonic mind–body split lingers in economics, that it has impaired our ability to understand the financial markets. If we want to understand how people make financial decisions, how traders and investors react to volatile markets, even how markets tend to overshoot sensible levels, we need to recognise that our bodies have a say in our risk-taking. Many economists might reiterate that the importance of money ensures that we act rationally where it is concerned; but perhaps it is this very importance which guarantees a powerful bodily response. Money may be the last thing about which we can remain cool.
Economics is a powerful theoretical science, with a growing body of experimental results. In fact many economists have come to question the assumption of a Spock-like rationality, even as a simplifying assumption, and a noteworthy group among them, beginning with the Chicago economist Richard Thaler and two psychologists, Daniel Kahneman and Amos Tversky, have started a rival school known as behavioural economics. Behavioural economists have succeeded in building up a more realistic picture of how we behave when dealing with money. But their important experimental work could today easily extend to the physiology underlying economic behaviour. And signs are some economists are heading that way. Daniel Kahneman, for one, has conducted research in the physiology of attention and arousal, and has recently pointed out that we think with our body.
He is right. We do. To understand just how our body affects our brain we should first recognise that they evolved together to help us physically pursue an opportunity or run away from a threat. When confronted by an opportunity for gain, such as food or territory or a bull market, or a threat to our well-being, such as a predator or a bear market, our brain sparks a storm of electrical activity in our skeletal muscles and visceral organs, and precipitates a flood of hormones throughout our bodies, altering metabolism and cardiovascular function in order to sustain a physical response. These somatic and visceral signals then feed back on the brain, biasing our thinking – our attention, mood, memory – so that it is in sync with the physical task at hand. In fact, it may be more scientifically accurate, although semantically difficult, to stop speaking in terms of brain and body at all, as if they were separable, and to speak instead of a whole-person response to events.
Were we to start viewing ourselves