The Hour Between Dog and Wolf

by John Coates

  Now ask yourself, which of these traders would you rather be? And do not assume Hare is out of a job. Losing a lot of money is often taken as a sign that you are a ‘hitter’, and can be rewarded with a job offer from another bank or hedge fund. If you are going to lose money in the finance industry, lose big.

  The fable of the two traders is simple enough, yet the strategic calculation underlying Hare’s choice of trading style has acted like an acid eating away at the integrity of our financial system. Anyone taking risks soon realises that their interests lie in maximising the volatility of their trading results and the frequency of their bonus payments. This strategy increases their chances of being paid at ‘high-water marks’, like the years when Hare made the bank $100 million. And what works for traders also works for their managers, and even the bank’s CEO: all have concluded that to maximise their long-term wealth they should focus on short-term profits. Besides, if next year all the Hares blow up, then all the banks blow up together, and no single person or bank looks bad.

  Perhaps most dangerous of all, though, is that with the backing of management, traders opting for Hare’s strategy are given the freedom to increase their risk just when the system least needs it, during bull markets. In this way risk-management and the insidious logic of bonus calculations work to amplify the destabilising biology of risk-taking.

  One way to tame these tidal waves of risk-taking and keep life on the trading floor safely between the tidelines is to institute a bonus scheme that pays traders once a business cycle (approximately four to five years), instead of once a year. If traders are profitable over a few years, they can begin to draw on their bonus pool. But if, like Hare, they lose all their profits after a few years, then they lose all previous bonuses. Banks could also increase the amount of the deferred bonuses the longer a trader remained profitable, effectively paying, say, 5 per cent on one-year returns, 7 per cent on two-year, 10 per cent on three-year, and so on.

  Risk managers for their part could spend more of their time reining in the trading stars, even pulling them off the floor for days at a time to give them a physiological cooling-off period, much like a rain break during a tennis match. The 2002 Sarbanes–Oxley Act in the US, designed to improve corporate governance and financial disclosure, encourages mandatory vacations during which there is to be no contact with the office. These vacations may have the inadvertent effect of breaking up physiological feedback loops and returning a risk-taker’s body to normal.

  Hiring policies too should be altered. When markets are roaring, banks hire as if growth will continue exponentially; and when the inevitable downturn comes, they fire just as indiscriminately. I have heard the hiring policies at banks referred to as a rotating door. I have also heard managers refer to trading floors, with their rapid turnover, as self-cleaning ovens. These practices work to exaggerate the stress once a crisis hits.

  If, however, bankers were hired in smaller numbers and, should they work out, received a long-term commitment from their employers, and if bonuses were calculated over a longer period of time, we would probably find that trading losses were a lot smaller, volatility in earnings reduced, and the need for layoffs during bad patches largely eliminated. If traders knew their long-term interests were served by prudent rather than reckless risk-taking, and if they further knew that prudent risk-taking guaranteed them secure employment, then I am willing to bet we would find much less irrational pessimism and risk-aversion just when the economy needs risk-takers.

  In short, nature and nurture, biology and management, both contribute to creating financial crises, and both need to be addressed if we are to mitigate them. I and my colleagues found evidence that management has more than enough clout to tame the beasts lurking within risk-takers. For we found, in one of the studies previously mentioned, both high testosterone levels and high Sharpe Ratios (i.e. high profits relative to the risk taken) in the same traders. How can that be? If testosterone increases a trader’s appetite for risk, could it not just as easily lead to rogue trading? Probably. But on the floor where we carried out the study, the managers employed a draconian risk-management system – pulling the plug quickly on losing trades and telling traders to sit on their hands when not in the zone – combined with a profit-sharing scheme, and this had effectively harnessed the traders’ risk appetite. On this trading floor, nature and nurture combined to encourage prudent and profitable risk-taking. In trading, as in sport, we concluded, biology needs the guiding hand of experience and well-structured incentives.

  There is a further step banks could take to help improve the health of their workers, and through this to stabilise risk-taking. That is by participating in what are called ‘wellness programmes’. A wellness programme is a form of preventive medicine, with the difference that the clinic running the programme is often located in a gym or in the workplace. One or two private medical companies in the UK and the US have combined the venues, placing medical clinics inside gyms, and locating these hybrid clinics inside offices. By doing so they have given employees the opportunity of seeing at one and the same time a personal trainer, a physiologist and a doctor. These programmes offer a unique way of surveying an employee’s life, from workplace to home to recreation to eating habits, in a manner that can help coordinate stress reduction. They also enable the medical company to spot trends in the health of a company’s employees. If it sees a high incidence of a certain musculo-skeletal disorder, it can look on the work floor for the cause. If it finds a high incidence of stress-related illness, it can similarly go looking for its cause.

  In short, once we come to understand the signals our bodies send us, including fatigue and stress, there is a great deal we as individuals can do to toughen ourselves against their ravages, and we as managers can do to minimise their impact. It is wise and far-seeing managers who put health and stabilised risk preferences at the top of their company’s agenda.

  NINE

  From Molecule to Market

  MANAGING THE BIOLOGY OF THE MARKET

  Financial crises are now occurring with alarming frequency, and with far greater severity than at any time since the Crash of 1929. This instability has been caused mostly by fundamental changes in the markets – historically low real interest rates; financial deregulation; low margin requirements and high leverage; the opening up of vast new markets in Asia and the emerging economies; and lastly, but importantly, the decline of partnerships on Wall Street, in the City of London and elsewhere, with an attendant shift in priorities from long-term to short-term profits. But the bull and bear markets resulting from these changes have been grossly exaggerated by the irrational exuberance and pessimism of risk-takers. And these, I have argued, are biological reactions to conditions of above-average opportunity and threat. Hormones – and the cascade of other molecular signals hormones trigger – may build up in the bodies of traders and investors during bull and bear markets to such an extent that they shift risk preferences, amplifying the cycle.

  Indeed, under the influence of pathologically elevated hormones, the trading community at the peak of a bubble or in the pit of a crash may effectively become a clinical population. In this state it may become price and interest-rate insensitive, and contribute greatly to the violence and intractability of runaway markets, to what Nassim Taleb has called‘Black Swan’ events. Perhaps this explains why central banks have met with such little success in arresting a bull market or placing a safety net under a crashing one. When building models of the risks facing a bank or an economy, risk managers and policy-makers should therefore bear in mind the likely clinical state of the trading community under extreme scenarios. Should the stock market drop 50 per cent in the next year, for example, then it is safe to assume the trading community will be in a traumatised state and may not respond to lower interest rates.

  One economist who fully understood the challenges for policy of non-rational decision-making was Keynes. He insightfully described how ‘animal spirits’ drive investment and market sentiment, but he
lacked any training in biology, so he never attempted to specify what exactly these animal spirits were. Nonetheless, as animal spirits bulked larger in his thinking, the less faith he had in the rate of interest as a tool for managing the economy. That is one reason he came to believe in fiscal policy, the state taking over the role of stabilising an economy that can no longer do it on its own. Keynes harboured doubts about the ideal of a life guided by, and public policy directed at, rational choice. He once humorously hinted at these doubts when recounting a conversation he had with his friend Bertrand Russell, the archrationalist philosopher. Russell, he recalled, claimed that the problem with politics was that it is conducted irrationally and that the solution was to start conducting it rationally. Keynes dryly commented that conversations along these lines were really quite boring. And they are, still, today.

  How, then, can we deal with irrational exuberance and pessimism? Can bank and fund managers and central bankers manage the biology of risk-takers? Here we are off any map drawn by rational-choice theory. We inhabit a culture dominated by Platonic and Cartesian ideals according to which reason is the ultimate arbiter of our decisions and behaviour. If we are indeed built this way, then to cure irrational behaviour, risk managers and policy-makers need only provide people – in this case traders and investors – with more information, or help them draw correct conclusions from the information they already have. Here the proposed cure for irrational risk-taking is a talking cure. Alternatively, governments and central banks could change prices in the market, such as the rate of interest, and let rational economic agents reallocate their spending and investing dollars accordingly. Unfortunately, the policies following from rational-choice theory have not been terribly successful in stabilising the market; and the ideal of rational choice itself has prevented us from building up any skill in dealing with a human biology run rampant, either at an individual level or at the level of policy.

  And this challenge is not isolated to the financial markets, for it occurs elsewhere as well. David Owen, the senior British politician and neurologist mentioned above, has been studying this problem in the political world. During his lengthy career in the House of Commons and then the House of Lords, stretching from the 1960s to the present, Owen has observed many political leaders succumb to something very like irrational exuberance, and their resulting hubris often wreaked havoc on the country. Owen recognises that this syndrome, acquired while exercising power, presents a conundrum for political theory: how do we protect the country from leaders who develop what amounts to a mental illness while holding office? Owen’s concerns echo those of central bankers who similarly face the problem of managing and containing the damage done by an unbalanced biology in the markets. Again, there is not much in our canon of economic and political theory to help us deal with these problems.

  Yet recent research in neuroscience and physiology has suggested that there is a great deal we can do. In the previous chapter we looked at some research which indicated ways in which individuals could recognise, control and toughen themselves against stress and hormonal imbalances. And we looked as well at how management could help dampen the stress response in the workplace. Trading managers could further recognise that the training and managing of risk-takers requires a lot more than imparting vast quantities of information to them; it crucially needs the training of skills. Risk managers too should rely as much on behavioural observation of risk-takers – one preferably informed by a basic knowledge of physiology – as on quantitative metrics. The reliance on metrics alone proved spectacularly unsuccessful in predicting and managing the credit crisis.

  There may be another way of defusing the explosive mix of hormones and risk-taking in the market, and that is by changing its biology.

  WOMEN IN THE FINANCIAL WORLD

  How do we do that? If a bull market is amplified by a testosterone feedback loop among traders and investors – and my own experience in trading, my and my colleagues’ experiments with traders, and other researchers’ studies of hormones strongly suggest it is – does this mean bubbles are largely a male phenomenon? If they are, could instability in the markets be reduced by having more women and older men employed in them? We know that market stability is served by having a diversity of opinions – we want some people buying while others sell – so perhaps the same could be said of biology, that market stability needs biological diversity. And women and older men have very different biologies from young men.

  Consider older men. Hormones change over the course of a man’s life (over a woman’s too). Testosterone levels in men rise until their mid-twenties, then go into a slow decline that accelerates after the age of fifty. At the same time, cortisol levels drift upwards. As they age, men may therefore become less and less susceptible to the testosterone feedback loops that I have argued can morph risk-taking into risky behaviour. In addition to their altered biology, older men bring to a bank or fund a lifetime of valuable experience. They have seen bad things happen – the Crash of ’87, say, or the Savings & Loan crisis of the late 1980s and early 1990s, when hundreds of US banks became insolvent – so they are less likely to jump into risks before thinking through a wide range of possible outcomes. Yet trading floors are traditionally hostile to older traders, perhaps because their slower reaction times or their more cautious attitude is misinterpreted as fear. But there is little evidence that age impairs the judgement of investors, or their ability to take risk. In fact most legendary investors, such as Warren Buffett and Benjamin Graham, achieved their status at a later stage in their lives, not as young men.

  Women, for their part, have very different biologies from men. They produce on average about 10–20 per cent of the amount of testosterone as men, and they have not been exposed to the same organising effects of prenatal androgens, so they too may be less prone to the winner effect than young men. Women’s stress response also differs substantially from men’s. One psychologist, Shelley Taylor, and her colleagues have in fact argued that the fight-or-flight reaction is more of a male response, and is not the default reaction to threat for women in quite the same way. A woman will indeed experience fight-or-flight if faced by a grizzly bear, just as a man will; but Taylor thinks that a woman’s natural reaction to threat, at least within the social situations which are today our normal environment, is what she calls the‘tend-and-befriend’ reaction, an urge to affiliation. She reasons that if you have children to care for, tend-and-befriend makes more sense than launching into a fist-fight or running away.

  As for their long-term stress response, women on average have the same levels of cortisol as men, and these are equally volatile. But research has found that women’s stress response is triggered by slightly different events. Women are not as stressed by failures in competitive situations as are men; they are more stressed by social problems, with family and relationships. What all these endocrine differences between men and women add up to is the following: when it comes to making and losing money women may be less hormonally reactive than men. Their greater numbers among risk-takers in the financial world could therefore help dampen the volatility.

  A question remains: if women could have such a tonic influence on the markets, why are there so few women traders? Why are women not pushing their way onto the trading floors, and why are banks and hedge funds not waving them in? Women make up at most 5 per cent of the traders in the financial world, and even that low number includes the results of diversity pushes at many of the large banks. The most common explanations ventured for these numbers are that women do not want to work in such a macho environment, or that they are too risk-averse for the job.

  There may well be a kernel of truth to these explanations, but I do not place much stock in them. To begin with, women may not like the atmosphere on a trading floor, but I am sure they like the money. There are few jobs that pay more than a trader in the financial world. Besides, women are already on the trading floor: they make up about 50 per cent of the sales force, and the sales force sits right next to th
e trading desks. So women are already immersed in the macho environment and are dealing with the high-jinx; they are just not trading. Also, I am not convinced women are as easily put off by a male environment as this explanation assumes. There are plenty of worlds once dominated by men that have come to employ more women: law and medicine, for example, were once considered male preserves but now have a more even balance between men and women (although admittedly not at the top echelons of management). So I am not convinced by the macho environment argument.

  What about the second-mentioned explanation, that men and women differ in their appetite for risk? There have been some studies conducted in behavioural finance which suggest that on computerised monetary choice tasks women are more risk-averse than men. But here again, I am not entirely convinced, because other studies, of real investment behaviour, show that women often outperform men over the long haul, and such outperformance is, according to formal finance theory, a sign of greater risk-taking. In an important paper called ‘Boys will be Boys’, two economists at the University of California, Brad Barber and Terrance Odean, analysed the brokerage records of 35,000 personal investors over the period 1991–1997 and found that single women outperformed single men by 1.44 per cent. A similar result was announced in 2009 by Chicago-based Hedge Fund Research, which found that over the previous nine years hedge funds run by women had significantly outperformed those run by men.

  Barber and Odean traced the women’s outperformance to the fact that they traded their accounts less. Men on the other hand tended to overtrade their accounts, a behaviour the authors take as a sign of overconfidence, a conviction on the part of the men that they can beat the market. The trouble with overtrading is that every time you buy and sell a security you have to pay the bid–offer spread plus any commission, and these costs add up so quickly that they substantially diminish returns. Is the superior performance of women risk-takers due to their lower transactions costs? Or is part of it due to higher risk-taking? Or perhaps to better judgement? How can we reconcile the experimental findings that women are more risk-averse with the data on their actual returns, which suggests either greater risk-taking or better judgement? There is a clue that may help solve this mystery.