Editor’s choice: Stress hormones may alter ability to take risk
This is our article of choice for today. It’s based on a report of a new study published by Cambridge University, showing that high levels of the stress hormone cortisol may contribute to the risk aversion and ‘irrational pessimism’ found among bankers and fund managers during financial crises.
We quote Dr. John Coates co-lead of the study from the Cambridge Judge Business School, and a former Wall Street derivatives trader himself who says: “ Any trader knows that their body is taken on a roller coaster 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.”
“It is frightening to realise 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.” He adds: “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.”
Here is an extract from the report:
“The study’s authors say that risk takers in the financial world exhibit risk averse behaviour during periods of extreme market volatility – just when a crashing market most needs them to take risks – and that this change in their appetite for risk may be “physiologically-driven”, specifically by the body’s response to cortisol. They suggest that stress could be an “under-appreciated” cause of market instability. Published in the journal Proceedings of the National Academy of Sciences, the study conducted at the Cambridge Judge Business School and the University’s Institute of Metabolic Science is the first to show that personal financial risk preferences fluctuate substantially, and these fluctuations may be linked to hormone response. The finding could fundamentally alter our understanding of risk as, up until now, almost every model in finance and economics – even those used by banks and central banks – rested on the assumption that traders’ personal risk preferences stay consistent across the market cycle, say the authors. In a previous study conducted with real traders in the City of London, researchers observed that cortisol levels rose 68% over a two week period when market volatility increased. In the latest study they combined field work with lab work, a rare approach in economics, to test for the effects of this elevated cortisol on financial risk-taking.”