Every so often we read of a star trader who lost so much money that he gave back all the profits he made over several years and shook his bank to its foundations. How does this happen? Were the bank's risk managers mistaken about this trader's skill?
Maybe. But recent research suggests an alternative explanation--that the winning streak changed the trader. Human biology can help explain what drives traders to acts of folly.
When we take on risk, including financial risk, we don't just think about it; we also prepare for it physically. Body and brain fuse as a single functioning unit. Consider what happens on the trading floor when news flashes across the wire. Traders' senses are placed on high alert. Breathing accelerates; a thumping heart gears up for action. Muscles tense, stomachs knot, and sweating begins, a sign of anticipatory cooling. We do not regard information as computers do, dispassionately. We register it physically.
My colleagues at the University of Cambridge and I have conducted a series of experiments on London trading floors and found that during a winning streak, our biology can overreact and our risk taking can become pathological. When males enter competition, their testosterone levels surge, increasing their hemoglobin and hence their blood's capacity to carry oxygen, and in the brain increasing their confidence and appetite for risk. The winner emerges with even higher levels of testosterone, and this heightens his chances of winning yet again, leading to a positive feedback loop known in animal behavior as the winner effect. For athletes preparing to compete, traders buying risky assets or even politicians gearing up for an election, this is a moment of transformation, what the French in the Middle Ages called "the hour between dog and wolf."
At some point in this upward spiral of testosterone and victory, however, judgment becomes impaired. Effective risk taking morphs into overconfidence, and traders on a winning streak may take on positions of ever increasing size with ever worsening risk-reward trade-offs.
What happens to traders' biology if these positions blow up? Their stress response goes into overdrive. The uncertainty people feel during a crisis can raise stress hormones and promote feelings of anxiety, a selective recall of disturbing memories and a tendency to find danger where none exists. The stress response may foster irrational risk aversion, impairing a person's ability to manage positions taken on in more optimistic times.
In short, traders' biology may cause them to take too much risk when on a winning streak and then too little when the market needs it most during a crisis. Risk managers at banks need to understand this biology. The statistical tools they rely on cannot catch the subterranean shifts taking place in their traders' risk appetite.
Risk managers could, however, learn from sports scientists how to spot and manage exuberance, fatigue and stress. They may have to manage their traders much as coaches manage their athletes. And that means occasionally pulling them off the field until their biology resets.
Coates, a research fellow at the University of Cambridge, was a trader at Goldman Sachs and Deutsche Bank. He is the author of The Hour Between Dog and Wolf