Could it be that Wall Street risk takers lose their risk-taking mojo precisely when they (and we) need it most? New research on the effects of the stress hormone cortisol suggests a paradox that could be at the very center of market crises.
Our brain directs the release of cortisol from our adrenal glands when we’re under stress, or even when we just think we’ll experience stress. The hormone triggers a state of body-wide alertness to threats, a sort of cerebral bracing for the impending stress storm. Previous research on stock traders in London showed that cortisol levels increased by 68% over a two-week period of market volatility. The latest study, published in the Proceedings of the National Academy of Sciences (PNAS), built on that research to dissect the behavioral effects of all that extra cortisol.
Researchers injected study participants with hydrocortisone (the Rx form of cortisol), which raised their cortisol levels by 69%, almost exactly the amount experienced by the London traders. They then had the participants play a lottery-style game designed to test their penchant for risk taking. The game required participants to evaluate variables similar to those one would evaluate when deciding on which stocks to invest in.
The results showed that brief initial spikes in cortisol didn’t have much of an effect. But sustained high levels of the hormone made participants significantly more risk averse: those under the influence of a steady flow of cortisol decreased their risk-taking appetite by about 44%.
"Any trader knows that their body is taken on rollercoaster ride by the markets. What we haven't known until this study was that these physiological changes—the sub-clinical levels of stress of which we are only dimly aware—are actually altering our ability to take risk," said Dr. John Coates, co-lead of the study from the Cambridge Judge Business School, and a former Wall Street derivatives trader.
"It is frightening to realize that no one in the financial world—not the traders, not the risk managers, not the central bankers—knows that these subterranean shifts in risk appetite are taking place."
What this study suggests is that the massive stress of ongoing market volatility, triggering a deluge of cortisol, could be the reason why traders become ultra-conservative at the very points at which a heartier appetite for risk could help a shaky market recover more quickly.
The researchers point out that the credit crises of recent memory all lasted far longer than the research period, and cortisol levels among traders likely remained perilously high throughout. The effect was decreased risk taking just when the economy needed it most—“when markets were crashing and needed traders and investors to buy distressed assets.”
"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. Risk managers who fail to understand this will have as little success as fire fighters spraying water at the tips of flames," added Coates.
You can find David DiSalvo on Twitter @neuronarrative and at his website, The Daily Brain. His latest book is Brain Changer: How Harnessing Your Brain’s Power To Adapt Can Change Your Life.