Coates: When we take investment risks, our bodies play as big a role as our brains

Coates: When we take investment risks, our bodies play as big a role as our brains

October 6th, 2013 John Coates in Opinion Columns

TO HEAR HIM SPEAK

Dr. Coates will be the keynote speaker at the 2013 Behavioral Finance Symposium Thursday, October 10, 11 a.m.-8 p.m., at the Doubletree Downtown Chattanooga.

The symposium is presented by the Galtere Institute: Finance for the Future Initiative at The University of Tennessee at Chattanooga College of Business. For more information, visit http://www.utc.edu/college-business/academic-programs/ffi/finance-symposium/

What happens to your body when you make or lose a lot of money? The answer to this question may affect the way you manage your money, and the way banks manage traders.

To many people this question seems odd, as if it just slightly misses the point. Most of us are taught that trading the markets, investing our savings, even running a business is a purely intellectual activity, involving the collection and processing of information. To make money we do indeed need to do our homework; but there is something more involved than pure thinking. For when we take risks, including financial risks, our body plays as large a role as our brain.

Anyone who doubts this should pause when next placing a bet in the markets and observe their own physical reactions. Your heart may speed up, breathing accelerate, pupils dilate, stomach tickled by the butterflies as blood is shunted away from the gut. You will recognize that financial risk taking is a very physical activity, and that it may have more in common with kicking a football than calculating like a computer.

Better yet, have someone close to you, your husband or wife, do the watching. I once put on a trade, selling the Yen against the U.S. dollar in the belief that the Bank of Japan would weaken the Yen. But I was wrong, dead wrong, and lost a lot of money. When I told my wife she said, I knew you were going to lose. I, being defensive and arrogant, challenged her: "What do you know about Japanese monetary policy?" to which she calmly replied, "Nothing. But I know you. And you were acting weird, your body language was all wrong."

I too observed this phenomena when running a trading desk on Wall Street. Traders on winning and losing streaks carried themselves differently, erect or stooped, puffed up or beaten down. Importantly, though, science is now finding that these physical changes feedback on the brain and change the amount of risk a trader takes.

Traders and investors on a winning streak often become euphoric, delusional, take too much risk, and with terrible odds, and eventually blow up. These people may be under the influence of a physiological mechanism known as "the winner effect," in which winning leads to increased risk taking. Winning raises testosterone, and this hormone increases lean muscle mass and the blood's capacity to carry oxygen, and in the brain elevates confidence and appetite for risk. People can get caught in an upward spiral of victory and rising testosterone which eventually makes them feel like Tom Wolfe's masters of the universe.

We see this regularly in the markets where big shot traders cripple their banks. But we also see it in fields afar remote, where successful people embark on aggressive over-expansion - CEOs, political and military leaders, and sports stars succumbing to "the red mist." Relentless victory leads to a dangerous transformation, what in my book I refer to as "the hour between dog and wolf."

Traders, anyone, losing money or wracked by uncertainty as they have been in the aftermath of the Credit Crisis present a more pathetic aspect. Chronic stress is nothing short of a torture. Stress hormones, which at low levels can be enjoyable (after all we pay to go on roller coasters), seep unceasingly out of our adrenal glands, poisoning our bodies and tormenting our minds. It is the uncertainty that does the most damage, leaving us in a constant state of vigilance, with high blood pressure, and elevated glucose and lipids in our blood, and causes us to recoil from risk. During financial crises, the masters of the universe often morph into whimpering pups, unable to take any risk without the guiding hand of the parental Fed.

If we are to manage these pathologies in risk taking, we need to first understand how body and brain work together, how this tag team has made us the most remarkable risk takers on the planet, but also how occasionally we can go awry. Risk managers need to be more like football coaches than they do statisticians. As for me, I have my wife.

John Coates, research fellow at Cambridge University, is the author of "The Hour Between Dog and Wolf: How Risk Taking Transforms Us, Body and Mind."