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Research Disputes Traditional Financial Risk Assumptions
Neuroscience paper links decision-making behavior to stress hormone Thursday,
March 06, 2014 ,
By Katherine Heires
Neuroscience researcher John Coates is reporting new progress in finding a link between human physiology and stress levels, its effect on decision-making and risk-taking, and how it ultimately plays out in markets and the economy at large.Coates, a former Goldman Sachs & Co. and Deutsche Bank trader who is currently research fellow in neuroscience and finance at the University of Cambridge, spells out his latest findings in "Cortisol Shifts Financial Risk Preferences." Focusing on effects of the stress hormone cortisol, the paper was co-authored with eight colleagues and published in February at the Proceedings of the National Academy of Sciences.
Funded by two U.K. entities, the Economic and Social Research Council and Medical Research Council, the research expands on ideas Coates laid out in his 2012 book, "The Hour Between Dog and Wolf: Risk-Taking, Gut Feelings and the Biology of Boom and Bust."
The cortisol paper states that many economic and market models, taking into account such factors as high-yield bond spreads, swap rates and equity price ratios, assume that individuals' risk preferences are stable. The Bank of England Global Risk Appetite Index, the IMF Risk Appetite Index and the Credit Suisse First Boston Risk Appetite Index, among others, operate on the idea that while market uncertainty can change and even reach crisis levels, individuals' risk outlooks stay the same.
"Outside of academia, this assumption about risk preferences …is widespread, but as we demonstrate, it is unsupported and wrong," Coates asserts. He finds it "truly bizarre" that economists and central banks thus rely on static indicators of risk appetite.
Similarly, Coates notes that companies that aggregate risk across departments -- or look at variances and covariances in an effort to better manage risk -- are not using metrics that explain the current shift in employee behavior, i.e., widespread risk avoidance. "They desperately need to understand what is driving (employees') risk aversions, but don't have the proper tools to do so," he says.
Untimely Reactions
The Cambridge researchers had previously found that financial traders exposed to high levels of uncertainty and volatility in markets experienced a sustained increase in cortisol levels. When this occurred, they became risk-averse for extended periods, in some instances missing out on profit-making opportunities.
"They were freezing up just when you don't want them to freeze up -- when the market offers the most opportunity," Coates explains.
For "Cortisol Shifts Financial Risk Preferences," the researchers conducted a more formal and controlled laboratory study of 20 male and 16 female volunteers. Specifically, it was a double-blind, placebo-controlled, cross-over protocol that induced an increase in cortisol levels equal to a previously studied rise in traders of 68% over an eight-day period. "This exposure borders on chronic stress, and could have effects on the brain," Coates says.
The subjects were asked to participate in computerized lotteries offering real monetary payoffs that are, according to the study's authors, a well-validated way of gauging changes in risk preferences. Participants receiving the cortisol became noticeably risk-averse, preferring lower-expected-return and lower-variance bets. Also, the weighting of probabilities became more distorted among men relative to women.
The scientists did not expect the magnitude of the change measured: 44% in risk-aversion behavior.
Coates deems that a "huge change, particularly given that most risk models assume that risk preferences don't change at all. Can you imagine what happened during the credit crisis? In fact, we know that risk-taking went down to zero, as traders would not trade any assets at one point."
High Degree of Variability
The study concludes that financial risk preferences can and do shift -- and substantially over time. These shifts occur under the influence of a physiological mechanism, the stress response, which is either unknown to, or largely ignored by, economists, analysts and others when endeavoring to better analyze or manage risk. The study suggests that financial firms and policy makers need to recognize that when people take risks, they are not just engaging in a cognitive process, but are reacting physiologically, complete with endocrine secretions priming them for impending activity.
"These changes then feed back on the brain, calibrating their appetite for risk to current circumstance," the report says, adding, "Our findings suggest that when people are stressed by chronic uncertainty or an uncontrollable threat, their endocrine systems discourage them from taking risk."
The report concludes, "It is therefore possible that rising stress hormones contributed to the widespread risk aversion during the [financial] crisis that came to be known as 'irrational pessimism.'"
Critical Viewpoints
Lawrence J. White, who holds the Robert Kavesh professorship in economics at New York University's Stern School of Business, says he is not ready to dismiss the usefulness of the risk indexes criticized by Coates and his team.
"Volatility and other types of risk indexes are rough-and-ready measures that do seem to allow us to understand market behavior better and under a wide set of circumstances," White comments. Regarding cortisol levels measured in a laboratory setting, he adds, "How is that going to help me when I am trying to figure out whether the market is in stress or not? Do I have to rush out and hook up a bunch of traders on the trading floor to find out?"
Also offering a different perspective is Peter Bossaerts, William D. Hacker professor of economics and management and professor of finance at California Institute of Technology, who is part of the school's interdisciplinary Behavioral and Social Neuroscience program and has conducted risk-related research at the Caltech Laboratory for Experimental Finance utilizing fMRI scanning. Bossaerts' tests indicate that one's ability to process risk is hard-wired into the brain and formatted like an algorithm, "not unlike the GARCH model of risk popular with quants." However, he has qualified his early research as "foundational" and not yet ready for use by risk managers.
For his part, Coates hopes that the scientific findings will result in some changes in how financial firms and others manage risk and employees who may be subjected to high stress levels. He has taken on several assignments and plans to form a consulting firm that will employ some of what he has learned about stress and human physiology. He aims to work with clients -- hedge funds, family offices and corporations -- that seek guidance in coping with high-stress situations.
"Once you understand the stress response and the fact that it's possible to have sub-clinical stress without being aware of it, you can understand that those levels can be a silent killer that makes people risk-averse," Coates says. The good news is that it is possible to build up resilience to these types of situations and to alter managerial behavior, to reduce the emergence of risk aversion behavior.
Coates adds: "When a crisis hits, you have to rein in middle management and switch to a support mode, reducing novelty and uncertainty so that people can take advantage of the risk opportunitiesthat do exist."
Katherine Heires (mediakat@earthlink.net) is a freelance business and technology journalist in the New York area and founder of MediaKat llc.
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