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The neuroscience of risk

4 min read

Modern Money

Traders may find it slightly disconcerting to learn what is going on inside their bodies when volatility rises and falls, says John Coates, senior research fellow in neuroscience and finance at the University of Cambridge and author of “The Hour Between Dog and Wolf: Risk Taking, Gut Feelings, and the Biology of Boom and Bust.” Coates, a former derivatives trader at Goldman Sachs and Deutsche Bank, says, “It is entirely possible that trading is an addictive behavior.”

The role biology plays in risk taking was a key topic during Coates’ keynote address, “New Research in Neuroscience & Finance; The Biology of Risk Taking,” at the Chicago Board Options Exchange Risk Management Conference in Carlsbad, Calif.

Why it important to study the neuroscience of risk

“Every blowup we’ve seen north of $1 billion that shakes a bank to its foundation is handed to us by traders at the end of a two- or three-year winning streak. Traders who thought they could walk on water and risk management thought they could as well. Something happens to traders when they are on a winning streak that transforms them from something tame to something a lot more dangerous.”

His research methodology

“We are looking at the physical side of trading. Rationality or irrationality never come up in what we do. We don’t talk about behavioral finance or psychology. We don’t do talking. We do the biology underlying the behavior.”

Whether traders should trust their “gut feelings”

“One of the most fascinating areas of the neurosciences right now is the discovery that gut feelings aren’t the stuff of legend. They are real physiological entities. … They are extremely valuable signals in informing our decision-making. In particular, the decisions we make when we take risk. … It is entirely possible that our thinking is at its least-diluted when we are sending commands to our muscles. So if we can read those commands in the form of gut feelings, we’re probably having access to our best judgment of the risks facing us. Which means that gut feelings may have a better assessment of risk than our conscience brain.”

The role testosterone plays in trading

“Traders put on a trade. They get an above average profit. Their testosterone levels rise. They put on an even bigger trade and this feedback loop starts going where they put on bigger and bigger trades. Unfortunately risk management is accommodating the process by increasing their risk limits because they are making money. … They put on trades that are too big … and they blow up.”

What risk managers can do to prevent the next big trading blow-up

“The financial community has to be aware that we have unstable risk preferences. Underneath our cool demeanor, our risk preferences are swinging back and forth. Once you understand the biology, you can do things like take a trader who is on a winning streak and instead of raising their risk limits, maybe tell them to close out their positions and take a three-week break to give the brain a break until the biology resets.”

Why policymakers may never correctly address risk in financial markets

“Policy is directed at the center of cognitive activity and it may be the wrong model. It assumes that financial risk-taking is a purely cognitive activity and that is just wrong. It’s not.”

During the question-and-answer portion of his appearance, Coates was asked why there are so few women on trading floors

“I don’t think it is risk aversion. … There is no difference in risk aversion between men and women. There is a difference though in the amount of information on which they are willing to act. Men will take a shred of information and put on a trade. Women don’t seem to want to do that. … Trading floors at banks may be 5% women, but when you look at asset managers in the City of London, they are 50 to 60% women. That’s risk-taking, but you have more time to make your decision.”