Better Trading Through Science

John Coates, a senior research fellow in neuroscience and finance at the University of Cambridge, has a theory. He says there would be fewer stock market bubbles and crashes if women and older men handled most of the trading. “There is less diversity in the financial world than in the military,” he quips. “On Wall Street, we have one slice of the population -- young men -- running our trading floors. That leads to extreme behavior: They go wilding.”

Wilding is not good for stocks. Such behavior likely contributed to the Internet crash in 2000 and the subprime-fueled crash of 2008-2009. So Coates, who spent 12 years trading fixed-income derivatives for Goldman Sachs and Deutsche Bank in New York, is now examining traders’ hormones for clues on how much risk women and older male traders are willing to take.

In 2007, Coates went to a trading floor and took repeated saliva samples from 250 traders, mostly young men. He found that in the mornings, when their testosterone levels were high, the traders’ confidence was also high. As they made winning trades, their testosterone levels rose even higher, leading to profits in the afternoon. The young men began to feel infallible, indulging in increasingly risky behavior, such as buying shares of overvalued stocks. But eventually too much testosterone, too much impaired judgment, would drive markets to unsustainable heights. Then the cycle could end. The overvalued stocks would crash and the testosterone levels would return to normal.

“Testosterone is the molecule that explains irrational exuberance,” says Coates. “A certain amount of testosterone can be healthy, but too much can lead to a bubble.”

Understanding the Irrational

For most researchers working in neuroscience, the holy grail is to discover how to regenerate the neurons of the brain. Such a feat would help scientists put an end to diseases such as Parkinson’s, Alzheimer’s and many forms of dementia. But others are taking the techniques of this growing field and applying them to behavioral finance, itself a mash-up of economics and psychology. The result is a new field called neuroeconomics, which attempts to explain how people manage risk and why they often make irrational decisions.

That emotions play a powerful role is nothing new. Benjamin Graham, considered the father of value investing, once said, “Individuals who cannot master their emotions are ill-suited to profit from the investment process.” But the core theories of the field now known as behavioral finance were developed by Richard Thaler, professor of economics and behavioral science at the Booth School of Business at the University of Chicago, and Daniel Kahneman of Princeton University, whose work on the questions, with the late Amos Tversky, won him the Nobel Memorial Prize in Economic Sciences in 2002.

Kahneman and Tversky found that people suffer a higher degree of pain from losing money than they feel pleasure from making money. So they tend to hold on to losing stocks rather than sell and lock in a loss.

Irrationality can also take the form of an emotional attachment to an asset. R.J. Weiss, the 26-year-old founder of the blog Gen Y Wealth, recently posted that he got caught in a behavior trap. When his grandfather passed away, he inherited shares trading at $25. As the shares fell to $20, to $10 and then to $5, Weiss couldn’t bring himself to part with his grandfather’s gift. Finally, in April, he sold at $3.04, locking in a 90 percent loss. “The entire time the stock plummeted, I knew [that holding] was the wrong thing to do. But I couldn’t get myself to sell it,” wrote Weiss.

Prevention Mechanisms

Dan Ariely, a behavioral economist at MIT, says people need to be cautioned against such irrationality, and that perhaps even mechanisms must be established to prevent people from acting rashly. “We know we need to create a mechanism that prevents people from texting while driving,” says Ariely. “But in the market, we’re not taking human character into account and that is leading us astray.”

First, though, neuroeconomists must understand the role of emotion in decision-making. Brian Knutson, a neuroscientist at Stanford University, and Camelia Kuhnen, a professor of finance at Northwestern’s Kellogg School of Management, scan the brains of investors while they make buy and sell decisions. They find that investors with the biggest appetite for risk have increased brain activity in an area called the nucleus accumbens. That’s the part that lights up in an animal when it finds food, or in a predator when it goes for the kill.

At the same time, there’s a surge in the feel-good chemical dopamine. It floods your brain when you anticipate doing something pleasurable or exciting such as sky diving, listening to music or having sex. A dopamine high can cause investors to engage in risky behavior.

Investors who are more risk-averse -- and less likely to jump into a hot stock -- show increased activity in a different part of the brain, the anterior insula, which plays a key role in emotions such as anxiety and pain. It’s the part that lights up when you get a whiff of a rotten egg or hear the hiss of a snake. “By deconstructing why investors get excited, and why they do what they do, we will design tools that can help people make better decisions,” says Knutson.

Safeguards Against Scams

One such tool Knutson is working on is a way to help prevent investors from becoming victims of financial scams. Knutson, whose work is funded by the Financial Industry Regulatory Authority (FINRA), is using brain-imaging technology to see what happens when investors are tempted by scammers. He says it may seem that victims would simply be ignorant people. However, it could be that victims are people whose brains get so excited about potential gains they can’t help but take the risk. Or maybe such victims are oblivious to fear. His findings could lead to a tool that safeguards investors.

Where is all this going? Perhaps one day investors and traders will have a biometric contraption connected to their computers. It could scan the prefrontal cortex of the brain, determine testosterone levels and measure sweaty palms in microseconds before warning you not to make a trade. Or today’s research could result in drugs that make people more rational.

“Within a few decades, performance-enhancing drugs will be part and parcel of our world,” says Hersh Shefren, a professor of behavioral finance at Santa Clara University. “Right now it’s science fiction, but science fiction often becomes science.”

A more immediate solution may come from John Coates’s research: Adjust the mix of traders to include more women and older men.

To contact the reporter on this story: Nikhil Hutheesing at nhutheesing@bloomberg.net

To contact the editor responsible for this story: Suzanne Woolley at swoolley2@bloomberg.net

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