Tuesday, June 12, 2012

Biology of Traders Leads to Bubbles and Busts

Normally, the body of a risk-taker purrs along efficiently — after all, our bodies have been crafted for the quick reactions and gut feelings we need to survive in a brutal world. But not always. Under circumstances of outrageous success or terrifying failure, our biology can overreact; and when this happens to traders and investors, they suffer an irrational exuberance or pessimism that can destabilize financial markets and wreak havoc on the wider economy.
To get an inkling of how this physiology works, consider the following scenario, in which a trader grapples with a rumor that the Fed may raise rates later that afternoon:
As 2:15 — the time of the announcement — approaches, trading on the screens dwindles. The floor goes quiet. The trader feels intellectually prepared. But the challenge he faces requires more than cognitive skill. He needs fast reactions, and energy for the hours ahead.
Consequently, his metabolism speeds up, ready to break down energy stores in liver, muscle and fat cells. Breathing accelerates, drawing in more oxygen, and his heart rate speeds up. Cells of the immune system take up position at vulnerable points of the body, ready to deal with injury and infection. And his nervous system, extending from the brain down into the abdomen, redistributes blood — constricting flow to the gut, giving him butterflies, and to the reproductive organs, since this is no time for sex — shunting it to major muscle groups in the arms and thighs as well as to the lungs, heart and brain.
The announcement will bring volatility, and a chance to make money. The trader feels a surge of energy as steroid hormones are synthesized by their respective glands and injected into his bloodstream. Steroids are powerful, dangerous chemicals — they change almost every detail of body and brain: his growth rate, lean-muscle mass, mood, even the memories he recalls — and for that reason their use is tightly regulated by the International Olympic Committee and the hypothalamus, the brain’s drug enforcement agency.
These past hours, the trader’s testosterone levels have been climbing. This steroid hormone, produced by men (and, in lesser quantities, by women) primes the trader for the challenge ahead, just as it does athletes preparing to compete and male animals to fight. Rising levels increase confidence and, crucially, appetite for risk. For the trader this is a moment of transformation, what the French since the Middle Ages have called “the hour between dog and wolf.”
The stress hormones adrenaline and cortisol surge out of the adrenal glands, and the cortisol travels to the brain, where it stimulates the release of dopamine, a chemical operating along neural circuits known as the pleasure pathways. At high levels, cortisol provides a nasty, stressful experience. But in small amounts, in combination with dopamine — one of the most addictive drugs known to the human brain — it delivers a narcotic hit, a rush that convinces traders that there is no other job in the world.
Finally, at 2:14, the trader leans into his screen, pupils dilated, breathing rhythmic, muscles coiled, body and brain fused for impending action. An expectant hush descends on global markets.
Read it at The New York Times
The Biology of Bubble and Crash
By John Coates

As a 22-year old, directly out of college, my first job was as a trader for a proprietary options market making firm. After approximately six months of intensive training, the reigns were taken off and I was allowed to begin trading on my own. This was the beginning of 2008, a year that would entail the largest financial crisis since the Great Depression.

The Federal Reserve’s actions that year were watched with increasing anticipation and markets responded violently on nearly every occasion. Reading this scenario brought me mentally (and to some degree physically) right back to that desk, watching prices change rapidly across six different monitors, searching for the best opportunities to make a profit. Those moments were both exhilarating and scary, as the market's direction could turn strongly against you at any moment.

As a young trader/adult, my over-confidence in those moments only became apparent after some costly mistakes and a couple years passed. Understanding the psychology and biology of traders/investors can certainly offer useful insight. For both firms and regulators hoping to create an environment that encourages “smarter” risk-taking, Coates’ recent work provides a good starting point for this exploration.

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