by John Coates
Away from the sports and battlefield you can feel something like a martial spirit creep through a rural population as hunting season approaches. In the autumn, throughout small towns in Canada and the northern United States, hardware shops display rifles, decoys, blinds and camouflaged clothing; grocery stores sell baskets of old apples and carrots, bait for the unsuspecting deer now grazing openly in farmers’ fields; and locals begin wearing their hunting fatigues weeks before the season actually opens. In these towns you can feel a muted excitement, not unlike the animation among children as Halloween approaches, the thrill of the fright. But in these small towns verging the boreal forest, as the harvest moon wanes and a hunter’s moon rises over stubbled fields, the spirit feels more like a bloodlust, and is unnerving. Come hunting season, most city folk with a cabin in the woods high-tail it out of there before the bullets start flying.
How long can elevated testosterone levels persist? Among animals the winner effect varies dramatically between species, in some lasting only a few minutes, in others a matter of months. And testosterone levels vary dramatically through the year, especially across the breeding season. Few studies exist of long-term hormone changes in humans, but the ones that do exist suggest that the rise and fall in baseline testosterone levels can be long-lasting. For example, men can experience lowered testosterone for up to six months after their partners give birth, while those re-entering the singles market after a divorce can have elevated testosterone for several years. Men living in urban areas, according to a study of the Aymara people in Bolivia, are reported to have higher average testosterone levels than people living in rural areas. In one international study, the residents of Boston were found to have significantly higher average testosterone levels than the Lese of the Congo, the Tamang of Nepal and the Ache of Paraguay. The data in these studies were based on small samples, so their interesting conclusions require further study, but they suggest that more competitive environments, such as a free market, may call forth higher levels of testosterone. In short, levels of testosterone can rise and fall for extended periods of time, even years.
There is some evidence that short-term fluctuations in hormone levels can be communicated to other people. For example, the rising and falling levels of an athlete’s testosterone can be mimicked in team-mates – one Wayne Gretzky or Michael Jordan can inspire even a bedraggled assortment of players to great heights of performance. Fans are also susceptible: one group of scientists took testosterone samples from fans before and after the 1994 football World Cup final between Brazil and Italy. Both teams’ supporters went into the game with elevated testosterone, but when Brazil had won their fans’ testosterone levels rose, while the Italians’ crashed. It appears that the runaway testosterone cycles of athletes – and the same could be true of political and military leaders – can be experienced vicariously by observers. This mechanism raises the prospect of large groups of people experiencing an upward spiral of confidence.
The literature on the winner effect, in both animals and athletes, certainly provides grounds for suspecting that a testosterone feedback loop may operate in the financial markets. Does testosterone rise with a win in the markets, and does this lead in turn to increased risk-taking? That is the question I hoped to answer. To do so I set up an experiment on the trading floor of a mid-sized firm in the City of London. The floor employed 250 traders, all but three of whom were men. They were all engaged in high-frequency trading, as described in Chapter 3, meaning they bought and sold securities, sometimes in sizes ranging up to $1 or $2 billion, but held their bets only for a matter of hours or minutes, sometimes mere seconds. They therefore occupied the same market niche as the black boxes.
These traders were therefore up against some of the world’s most sophisticated and well-capitalised competitors. They lacked the large capital base and informational advantages of the flow traders at the big banks, and the deep pools of capital and inhuman processing speeds of the black boxes. Yet they were astonishingly successful: David against Goliath, John Connor against the Terminator. In fact they were some of the best traders I have ever seen: highly disciplined, consistent, and profitable.
I sampled testosterone from these traders and recorded P&L over a two-week period. What we found was that their testosterone levels were significantly higher on days when they made an above-average profit. More intriguing, though, was what we found when we looked at testosterone levels in the morning, because these predicted how much money the traders would make in the afternoon. When the traders’ morning testosterone levels were high, they went on to make a lot more money in the afternoon than they did on days when their morning testosterone levels were low (see fig. 9). Moreover, the difference in P&L between high- and low-testosterone days was large, amounting in statistical terms to one full standard deviation, a difference that if annualised could amount for some of the traders to over $1 million in pay.
This was a troubling finding. Efficient market theorists tell us that the market is random, and therefore no trait we possess can affect our trading and investment returns. It should not matter how intelligent you are, how well you did at school, how thoroughly you were trained – all these have as little effect on your returns as they do on your ability to roll a dice. If that is the case, how on earth can a molecule affect the amount of money you make?
My colleagues and I found further evidence that this molecule influences a trader’s profitability, and we did so more or less by chance. When I was on the trading floor conducting the first study, I brought a stack of science papers with me to read during downtime. One of these recounted an experiment in which the author, John Manning, had taken handprints from a group of football players, and found that their ability and success could be predicted from the lengths of their index and ring fingers, and specifically from the ratio of the two. This ratio, known as 2D:4D, meaning second digit length divided by fourth, could predict sporting ability because, Manning claimed, it gauged the amount of testosterone the athletes had been exposed to in the womb, a longer ring finger relative to index indicating higher androgen exposure. The idea at first seemed crazy to me, but also fun, so I began collecting handprints from traders. Later, when the back office of the trading firm sent me the P&Ls of these traders, I found to my amazement that their 2D:4D ratios predicted their profitability over the previous two years. What was even more astonishing was that their 2D:4D ratios predicted how long these traders had survived in the business. The results suggested that a hormone these individuals had been exposed to before they were even born was predicting their lifetime performance in high-frequency trading.
Fig. 9. Morning testosterone levels predict a trader’s afternoon profits. Each of seventeen traders is listed along the bottom axis. Lighter bars indicate the trader’s afternoon P&L when his morning testosterone was low relative to his median level during the study; darker bars when it was high. (P&L numbers have been transformed. This result can be reported more accurately as panel data. See endnote.)
What is going on here? When looking into the science behind the 2D:4D marker, we learned the following. Recall the surge in prenatal testosterone, occurring between the eighth and nineteenth week of gestation? This hormone has such powerful effects on masculinising the foetus that it leaves traces all over his body, which later in life can be read off as a measure of prenatal androgen exposure, much like the high-water marks on a breakwater. 2D:4D is just one of these traces. There are others, and they are equally bizarre, like oto-acoustic emissions, inaudible sonar-like clicking in the inner ear whose frequency correlates with prenatal testosterone levels; as does ridge-count asymmetry in fingerprints; or ano–genital distance, which is exactly what it sounds like. In many hospitals ano–genital distance is now routinely measured in newborns as a way of ascertaining if they have been exposed to an abnormal prenatal steroid environment, something that can be caused by environmental hormone disruptors, in other words chemicals we put in the environment that act like oestrogens and can cause development
al problems in males, such as undescended testicles and, later in life, prostate cancer. But alas, ano–genital distance is not a marker that is readily collected from traders, although it was suggested that if we were to leave a photocopier in the middle of the office Christmas party we might end up with some samples.
Barring that option, the finger-length ratio 2D:4D has proved the most convenient measure of prenatal androgen exposure for behavioural studies. Some studies have argued that it is a reliable measure of foetal testosterone production because a class of genes, called hox-a and hox-d, code for – to use the delightful title of a science article – fingers, toes and penises.
A vital question remains: how is testosterone having its effects on P&L? It may be that testosterone is affecting the traders’ performance by increasing their appetite for risk or their confidence. Equally, it may stabilise their visual attention, reduce distractions from irrelevant information, maintain search persistence, or augment visuo-motor skills such as scanning and speed of reactions, thereby permitting traders to spot price anomalies faster than their competitors. We will not know which of these aspects of their skill are affected until we have completed more controlled studies in the laboratory.
But we did make some headway in answering this question in the previously discussed study that looked at traders’ Sharpe Ratios, in other words how consistently they made money, their P&L corrected for the amount of risk they took in making it. In this study we used the traders’ Sharpe Ratios as a measure of skill, and asked quite simply, does testosterone improve traders’ skill, or does it increase the amount of risk they take? What we found was that testosterone did not improve their Sharpe Ratios, but it did increase the risk they took. We retain the belief that testosterone also has effects on the traders’ visuo-motor scanning and speed of reactions, although we will not be able to test this in the field. What our trading-floor studies did highlight, however, was that testosterone, a signal from the body, was having a large effect on the risk-taking of traders, rising with above-average profits and increasing risk-taking. These experiments thus provided good preliminary evidence that the winner effect does in fact occur in the financial markets.
EXUBERANCE
In the next few days Scott doubles his core position to 4,000 S&P contracts. At this point warning bells go off in the risk-management department of the bank, and Scott is asked to justify his decision. He takes the risk managers through his logic, as he has already done with Stefan and Ash. The risk managers understand his reasoning, may even agree with it, but they still have grave concerns. What happens in a crisis? What happens when the market begins to worry about credit risk? Right now everyone seems blissfully unaware of that danger.
Risk managers are usually pretty sharp-eyed about these things, often being former traders themselves – send a thief to catch a thief – and possess an enviable competence in statistics. But, alas, they lack clout. At the end of the discussion it is Ash and the desk managers who have the final say. And here, unfortunately, we find management practices and compensation schemes magnifying the biological forces that push traders to take more risk. Scott has made money for the past few years, and this year he is on a roll. Why rein him back, managers ask themselves. More decisively, where is our interest in doing so? Our year-end bonus is calculated as a percentage of our P&L, both for individual traders and for managers, so we want to make as much money as possible in this calendar year. Who cares if our positions or strategies blow up next year? We don’t give back previous bonuses. So it is in Scott’s, and his managers’, interest to take large risks. In fact, there is a subtle pressure on trading floors to constantly engage with the market, to take risks. I once went through a period of inactivity, pacing the floor like Hamlet, racked by indecision – to trade or not to trade – and my boss, failing to appreciate the depths of my existential angst, told me quite simply, ‘Coates, shit or get off the pot.’
Scott receives permission to increase his position, and one day when the market dips 1.5 per cent on bad economic news, he buys another 1,000 contracts. With a core position of 5,000 contracts he makes or loses $3.25 million if the market moves up or down 1 per cent – or $32.5 million if it drops 10 per cent. The sheer magnitude of the risk tinges his waking hours with fear, but below that, more powerful, simmers a confidence, an unshakeable belief in his ability to dominate the world. Exercising his skill in this way, Scott against the market, makes him feel keenly alive, and his life seems to accelerate. Like an adolescent discovering his strength, Scott flexes his new powers, from his brain right down to the ends of his fingers. His mind, quick and lithe, moves from thought to thought effortlessly, although to outsiders it appears he cannot keep his thoughts on track; he needs less sleep, and the potent cocktail of dopamine and testosterone being stirred in his brain fills him with a life-enhancing euphoria.
Others on the desk catch the mood, place copycat trades, and together they revel in an ecstasy of risk. Ash escorts a new saleswoman down the aisle to her desk, and behind her, just shy of her field of vision, a human wave follows as arb traders, peering over screens, check her out.
Normally these moments of profit and cockiness build, crest and wane. But not in a bull market. There is no downtime. Traders get on a roll and stay there, and under such circumstances their physiology does not have a chance to return to normal. It is at this point that they enter what may be called the end-game of the winner effect.
IRRATIONAL EXUBERANCE
What an extraordinary mechanism of empowerment the winner effect is. By its means a single person could conquer the world, or so it must feel. How far can these feedback loops run? Not surprisingly, they cannot go on forever. Biologists have found that the effects of testosterone on risk-taking among animals display the same n-shaped dose–response curve that we have encountered before, in Berlyne’s hill for example. At low levels of testosterone an animal will lack motivation, arousal, energy, speed and so on, but as testosterone levels rise so too does the animal’s performance in competitions and fights. When testosterone reaches its high point on the curve the animal enjoys optimal performance. It is in the zone. However, should testosterone continue to rise, the animal begins to slide down the other side of the hill, and its risk-taking becomes increasingly foolish. Male animals experiencing a sustained rise in testosterone tend to start more fights, patrol larger areas, venture into the open more, and neglect parenting duties, all of which lead to increased predation and reduced survival. At some point, as testosterone builds up in these animals, confident risk-taking morphs into overconfidence and rash behaviour.
Equally powerful psychological effects have been documented among athletes and recreational users who are ‘ripped’ on anabolic steroids. Pope and Katz, two psychiatrists from Harvard, found that many of these people succumb to mania, a psychiatric disorder in which the patient becomes euphoric and delusional, and experiences racing thoughts and a diminished need for sleep. In one case, a university athlete on steroids, after buying a sports car he could not afford, became so convinced of his invincibility that he asked a friend to film him driving the car into a tree, to prove he could not be hurt. In other cases, users of steroids have committed criminal acts, and in their defence have blamed their behaviour on testosterone, a legal strategy that has come to be known as ‘the dumbbell defence’. We have to interpret these cases with caution, because the athletes were taking steroids at levels far higher than can occur naturally in our bodies. Yet their behaviour is not unlike what I observed in many traders during the dot.com bubble.
There is a further cost of high testosterone. Elevated testosterone, and the larger or more ornamented body it promotes, is energetically expensive, and can eventually wear down an animal’s body. Castrate a male animal and it can live up to 30 per cent longer. High-testosterone males thus end up paying a high price for their show of strength and their triumphs, in the form of a higher rate of mortality. It has been said that there is a certain tragic glory to these highly charged males �
� ‘The candle that burns twice as bright burns half as long.’ Achilles and Macbeth, it might be said, did not suffer at the hands of the gods; they paid the price for high testosterone. Today something of this tragic spirit still hangs about the figure of an extreme male, fighting to assert himself against ultimate failure. It is almost as if they know they are doomed. Many men sense that beyond the sports field, the battlefield, and perhaps the trading floor, testosterone no longer plays a useful role in the workplace or in society. They feel it is just a matter of time before age and the gods of the service economy crush them.
In the financial world, testosterone feedback loops, once they start, can cause traders to pass through the early stages of thrill and excitement, and end up convinced of their own infallibility. As these cycles rise to their euphoric high point, one finds traders, most of whom are young males, with impaired judgement, doing dangerously silly things. Following the pattern of the winner effect, traders experience a rise in testosterone when their trades make money, which increases their confidence and appetite for risk, so that in the next round of trading they put on even larger trades. If they win again, as they are likely to during a rising market, their profits will increase their testosterone once more, until at some point confidence becomes over-confidence, trading positions grow to a dangerous size, and the risk–reward profiles of the trades start to stack the odds against them. But no matter; in their overconfident state, traders are convinced they will win anyway. As is management. When a trader makes more and more money, managers expand his risk limits apace. As a result traders are walking time-bombs, and banks invariably light the fuse, dangling before them huge risk limits and bonus payments that have exceeded $100 million. No wonder the traders responsible for bank-crippling losses frequently turn out to be the stars of yesterday. Banking is an odd world. I know of no comparable behaviour among surgeons or air-traffic controllers.
