This long article has more to do with investing and
its relation to stress and risk management.
However, it does bring out the biology of stress and its relationship to
risk taking. The really interesting
thing to me is that increased stress leads to LESS risk taking during times of
economic upheaval, therefore missing opportunities and in fact increasing the
likelihood of economic downturn. But be
warned, this is a slow complex read....
Tai chi is definitely the middle way, reducing stress
but hopefully keeping us engaged to life as it is (and therefore the
opportunities that arise in the normal course of “stressful” lives.) By reducing our biological stressors, we are
then better equipped to evaluate which risks are better bets and which are
not.
This article notes that a certain amount of
uncertainty in the markets keeps investors on their toes. If they feel too comfortable (tai
chi=collapsed) they ignore the dangers in front of them and respond
inadequately. By not giving into stress
when uncertainty appears, they make better choices.
Again, the body drives decision making beyond our conscious
recognition.
The Biology of Risk
By
JOHN COATES
New
York Times, JUNE 7, 2014
SIX
years after the financial meltdown there is once again talk about market
bubbles. Are stocks succumbing to exuberance? Is real estate? We thought we had
exorcised these demons. It is therefore with something close to despair that we
ask: What is it about risk taking that so eludes our understanding, and our
control?
Part
of the problem is that we tend to view financial risk taking as a purely
intellectual activity. But this view is incomplete. Risk is more than an intellectual puzzle — it is a profoundly physical
experience, and it involves your body. Risk by its very nature threatens to
hurt you, so when confronted by it your body and brain, under the influence of
the stress response, unite as a single functioning unit. This occurs in
athletes and soldiers, and it occurs as well in traders and people investing
from home. The state of your body predicts your appetite for financial risk
just as it predicts an athlete’s performance.
If
we understand how a person’s body influences risk taking, we can learn how to better
manage risk takers. We can also recognize that mistakes governments have made
have contributed to excessive risk taking.
Consider
the most important risk manager of them all — the Federal Reserve. Over the
past 20 years, the Fed has pioneered a new technique of influencing Wall
Street. Where before the Fed shrouded its activities in secrecy, it now informs
the street in as clear terms as possible of what it intends to do with
short-term interest rates, and when. Janet L. Yellen, the chairwoman of the
Fed, declared this new transparency, called forward guidance, a revolution; Ben
S. Bernanke, her predecessor, claimed it reduced uncertainty and calmed the
markets. But does it really calm the markets? Or has eliminating uncertainty in
policy spread complacency among the financial community and actually helped
inflate market bubbles?
We
get a fascinating answer to these questions if we turn from economics and look
into the biology of risk taking.
ONE
biological mechanism, the stress response, exerts an especially powerful
influence on risk taking. We live with stress daily, especially at work, yet
few people truly understand what it is. Most of us tend to believe that stress
is largely a psychological phenomenon, a state of being upset because something
nasty has happened. But if you want to understand stress you must disabuse
yourself of that view. The stress
response is largely physical: It is your body priming itself for impending
movement.
As
such, most stress is not, well, stressful. For example, when you walk to the
coffee room at work, your muscles need fuel, so the stress hormones adrenaline
and cortisol recruit glucose from your liver and muscles; you need oxygen to
burn this fuel, so your breathing increases ever so slightly; and you need to
deliver this fuel and oxygen to cells throughout your body, so your heart
gently speeds up and blood pressure increases. This suite of physical reactions
forms the core of the stress response, and, as you can see, there is nothing
nasty about it at all.
Far
from it. Many forms of stress, like playing sports, trading the markets, even
watching an action movie, are highly enjoyable. In moderate amounts, we get a
rush from stress, we thrive on risk taking. In fact, the stress response is
such a healthy part of our lives that we should stop calling it stress at all
and call it, say, the challenge response.
This
mechanism hums along, anticipating challenges, keeping us alive, and it usually
does so without breaking the surface of consciousness. We take in information
nonstop and our brain silently, behind the scenes, figures out what movement
might be needed and then prepares our body. Many neuroscientists now believe
our brain is designed primarily to plan and execute movement, that every piece
of information we take in, every thought we think, comes coupled with some
pattern of physical arousal. We do not process information as a computer does,
dispassionately; we react to it physically. For humans, there is no pure
thought of the kind glorified by Plato, Descartes and classical economics.
Our
challenge response, and especially its main hormone cortisol (produced by the
adrenal glands) is particularly active when we are exposed to novelty and
uncertainty. If a person is subjected to something mildly unpleasant, like
bursts of white noise, but these are delivered at regular intervals, they may
leave cortisol levels unaffected. But if the timing of the noise changes and it
is delivered randomly, meaning it cannot be predicted, then cortisol levels
rise significantly.
Uncertainty
over the timing of something unpleasant often causes a greater challenge response
than the unpleasant thing itself. Sometimes it is more stressful not knowing
when or if you are going to be fired than actually being fired. Why? Because
the challenge response, like any good defense mechanism, anticipates; it is a
metabolic preparation for the unknown.
You
may now have an inkling of just how central this biology is to the financial
world. Traders are immersed in novelty and uncertainty the moment they step
onto a trading floor. Here they encounter an information-rich environment like none
other. Every event in the world, every piece of news, flows nonstop onto the
floor, showing up on news feeds and market prices, blinking and disappearing.
News by its very nature is novel, adds volatility to the market and puts us
into a state of vigilance and arousal.
I
observed this remarkable call and echo between news and body when, after
running a trading desk on Wall Street for 13 years, I returned to the
University of Cambridge and began researching the neuroscience of trading.
In
one of my studies, conducted with 17 traders on a trading floor in London, we
found that their cortisol levels rose 68 percent over an eight-day period as
volatility increased. Subsequent, as yet unpublished, studies suggest to us
that this cortisol response to volatility is common in the financial community.
A question then arose: Does this cortisol response affect a person’s risk
taking? In a follow-up
study,
my colleagues from the department of medicine pharmacologically raised the
cortisol levels of a group of 36 volunteers by a similar 69 percent over eight
days. We gauged their risk appetite by means of a computerized gambling task.
The results, published recently in the Proceedings of the National Academy of
Sciences, showed that the volunteers’ appetite for risk fell 44 percent.
Most
models in economics and finance assume that risk preferences are a stable
trait, much like your height. But this assumption, as our studies suggest, is
misleading. Humans are designed with shifting risk preferences. They are an
integral part of our response to stress, or challenge.
When
opportunities abound, a potent cocktail of dopamine — a neurotransmitter
operating along the pleasure pathways of the brain — and testosterone
encourages us to expand our risk taking, a physical transformation I refer to
as “the hour between dog and wolf.” One such opportunity is a brief spike in
market volatility, for this presents a chance to make money. But if volatility
rises for a long period, the prolonged uncertainty leads us to subconsciously
conclude that we no longer understand what is happening and then cortisol
scales back our risk taking. In this way our risk taking calibrates to the
amount of uncertainty and threat in the environment.
Under
conditions of extreme volatility, such as a crisis, traders, investors and
indeed whole companies can freeze up in risk aversion, and this helps push a
bear market into a crash.
Unfortunately,
this risk aversion occurs at just the wrong time, for these crises are
precisely when markets offer the most attractive opportunities, and when the
economy most needs people to take risks. The real challenge for Wall Street, I
now believe, is not so much fear and greed as it is these silent and large
shifts in risk appetite.
I
consult regularly with risk managers who must grapple with unstable risk taking
throughout their organizations. Most of them are not aware that the source of
the problem lurks deep in our bodies. Their attempts to manage risk are
therefore comparable to firefighters’ spraying water at the tips of flames.
The
Fed, however, through its control of policy uncertainty, has in its hands a
powerful tool for influencing risk takers. But by trying to be more
transparent, it has relinquished this control.
Forward
guidance was introduced in the early 2000s. But the process of making monetary
policy more transparent was in fact begun by Alan Greenspan back in the early
1990s. Before that time the Fed, especially under Paul A. Volcker, operated in
secrecy. Fed chairmen did not announce rate changes, and they felt no need to
explain themselves, leaving Wall Street highly uncertain about what was coming
next. Furthermore, changes in interest rates were highly volatile: When Mr.
Volcker raised rates, he might first raise them, cut them a few weeks later,
and then raise again, so the tightening proceeded in a zigzag. Traders were put
on edge, vigilant, never complacent about their positions so long as Mr.
Volcker lurked in the shadows. Street wisdom has it that you don’t fight the
Fed, and no one tangled with that bruiser.
Under
Mr. Greenspan, the Fed became less intimidating and more transparent. Beginning
in 1994 the Fed committed to changing fed funds only at its scheduled meetings
(except in emergencies); it announced these changes at fixed times; and it
communicated its easing or tightening bias. Mr. Greenspan notoriously spoke in
riddles, but his actions had no such ambiguity. Mr. Bernanke reduced
uncertainty even further: Forward guidance detailed the Fed’s plans.
Under
both chairmen fed funds became far less erratic. Whereas Mr. Volcker changed
rates in a volatile fashion, up one week down the next, Mr. Greenspan and Mr.
Bernanke raised them in regular steps. Between 2004 and 2006, rates rose .25
percent at every Fed meeting, without fail... tick, tick, tick. As a result of
this more gradualist Fed, volatility in fed funds fell after 1994 by as much as
60 percent.
In
a
speech
to the Cato Institute in 2007, Mr. Bernanke claimed that minimizing uncertainty
in policy ensured that asset prices would respond “in ways that further the
central bank’s policy objectives.” But evidence suggests that quite the
opposite has occurred.
Cycles
of bubble and crash have always existed, but in the 20 years after 1994, they
became more severe and longer lasting than in the previous 20 years. For
example, the bear markets following the Nifty Fifty crash in the mid-70s and
Black Monday of 1987 had an average loss of about 40 percent and lasted 240
days; while the dot-com and credit crises lost on average about 52 percent and
lasted over 430 days. Moreover, if you rank the largest one-day percentage
moves in the market over this 40-year period, 76 percent of the largest gains
and losses occurred after 1994.
I
suspect the trends in fed funds and stocks were related. As uncertainty in fed
funds declined, one of the most powerful brakes on excessive risk taking in
stocks was released.
During
their tenures, in response to surging stock and housing markets, both Mr.
Greenspan and Mr. Bernanke embarked on campaigns of tightening, but the
metronome-like ticking of their rate increases was so soothing it failed to
dampen exuberance.
There
are times when the Fed does need to calm the markets. After the credit crisis,
it did just that. But when the economy and market are strong, as they were
during the dot-com and housing bubbles, what, pray tell, is the point of
calming the markets? Of raising rates in a predictable fashion? If you think
the markets are complacent, then unnerve them. Over the past 20 years the Fed
may have perfected the art of reassuring the markets, but it has lost the power
to scare. And that means stock markets more easily overshoot, and then
collapse.
The
Fed could dampen this cycle. It has, in interest rate policy, not one tool but
two: the level of rates and the uncertainty of rates. Given the sensitivity of
risk preferences to uncertainty, the Fed could use policy uncertainty and a
higher volatility of funds to selectively target risk taking in the financial
community. People running factories or coffee shops or drilling wells might not
even notice. And that means the Fed could keep the level of rates lower than otherwise
to stimulate the economy.
It
may seem counterintuitive to use uncertainty to quell volatility. But a small
amount of uncertainty surrounding short-term interest rates may act much like a
vaccine immunizing the stock market against bubbles. More generally, if we view
humans as embodied brains instead of disembodied minds, we can see that the
risk-taking pathologies found in traders also lead chief executives, trial
lawyers, oil executives and others to swing from excessive and ill-conceived
risks to petrified risk aversion. It will also teach us to manage these risk
takers, much as sport physiologists manage athletes, to stabilize their risk
taking and to lower stress.
And that possibility opens up exciting
vistas of human performance.
