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Investing Basics

Traders’ Narcotic of Choice (It’s Not What You Think)

Most research into economic booms and busts studies statistical information or consumer sentiment, or as the Wall Street Journal puts it “economics from the neck up”.

Articles by Betterment Editors

By the Editorial Staff
Betterment Resource Center  |  Published: June 21, 2012

John Coates (a research fellow at Cambridge University) chose instead to study the physiological effects of risk on the body.

What did he find?

Some stuff we already know:

  • When alerted to danger, the body releases powerful chemicals into the blood stream– making humans efficient risk takers. The mind is intellectually prepared, but the body too, is wired to act fast and sustain energy under pressure.
  • Under stress, the body produces cortisol and adrenaline, which stimulate the release of dopamine in the brain (one of the most addictive drugs known to the human brain).
  • In small amounts, this chemical combination provides a pleasurable and highly addictive narcotic hit.

New stuff:

  • In large amounts, these naturally occurring narcotics can transform a trader from being a prudent risk-taker to being irrationally overconfident (rising levels increase confidence and appetite for risk).
  • Coates found that under circumstances of outrageous success or terrifying failure, our biology can overreact: higher testosterone leading to greater risk-taking, and high levels of the stress hormone cortisol promoting chronic risk aversion.
  • Coates argues this overreaction could cause unstable markets: risk aversion driving a bear market into a crash, or excessive risk-taking (while at first assisting above-average profits) ultimately replacing rational risk-assessment with certainty (overconfidence bias).

Coates (a self professed former cocky trader) suggests some potential solutions to stabilize the market: a more even balance within banks between men and women, young and old. The logic behind this is that lower testosterone equals a lower likelihood of behavioral biases.

People talk about this in other spheres too, like the government and military. Regardless of whether Coates’ reasoning in this instance is correct (is it too simplistic to think that increasing women in the workplace will stabilize markets or increase world peace for that matter?) increased diversity can never be a bad thing…

However his second suggestion is fairly out there: look to sports scientists for guidance, because they’re the experts in managing biology in the interests of performance.

It’s a fascinating idea – and if any industry can afford to pursue radical new techniques, it’s this one.

We’re intrigued to see what comes of this research …

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