When hormones control investment decisions

Over the last several years, I have explored the impact of behavioral and structural biases in markets, as well as how they impact investment decision making. Recently I have been reading about the physiological changes that occur in our body and brain in response to stress and uncertainty, and how that can impair our decision making abilities.

Evolution has served mammals well over the last few million years. However, evolution is a long process, and the genetic encoding that we have today has probably not incorporated the sociological, environmental and technological changes that have happened over the last 50-100 years. Therefore our responses to events, such as market volatility, are still based on the neurological responses that have helped mankind escape from being eaten by a bear or tiger, as opposed to intraday price movements in mortgage backed securities.

In his fascinating book “The hour between Dog and Wolf”, John Coates, a former trader who retrained as a neuroscientist, discusses how the very wiring that helped us escape danger in the wild hurts our decision making abilities in modern social (and market) circumstances. I would highly recommend reading the book for a perspective into both trading and how the human brain works.

In many ways, hormone induced irrationality helps us – in addition to providing a response to imminent danger, hormones such as dopamine have instilled in us a sense of adventure and desire to explore “for the heck of it”, whether its an expedition to the South Pole, or finding black holes, or creating text messages that disappear after your read them.

However, it appears that our body has not learnt how to differentiate between physical, social and psychological sources of danger, and responds in the same way to all of them. When placed in environments that are novel, uncertain or uncontrollable, our body responds by placing us on high alert, and setting ourselves up for “fight or flight”, releasing stress hormones such as cortisol, and provides energy to certain functions of the body while shutting off others. High levels of hormones such as cortisol however, can impair our decision making abilities, and shut off what we consider “rational thought”.

In markets and investing, we are unfortunately typically placed in situations where we have to make decisions, both as individuals and organizations, at moments when our physiology has placed us in a state where we cannot make rational decisions. As a result, instead of a rational response to new information, as modeled by proponents of the efficient markets hypothesis, the response to new information tends to be irrational, driven by the hormonal and physiological changes that happen to us in response to stress.

There are three important implications of this:

Markets can be irrational, and remain irrational – the response to information can be irrational if market participants have been exposed to recent prior information or outcomes that have have triggered either stress related responses within them, or testosterone driven appetite for greater risk.
Decision making can be flawed – A time of uncertainty where events are uncontrollable is also when humans are least capable of rational thought – for example a trading desk or position that has had gone through a sudden unanticipated loss. However, this is also the time when we see people huddling together in conference rooms and trying to decide what to do.
Systematic processes can help – If we recognize that we are unlikely to make rational decisions at times of stress, then developing a pre-defined systematic plan, process or response, based on analysis of data, scenarios and other factors, may help overcome our inability to think rationally at moments of stress.

While reading about how our brain and body communciate under stress I realized why meditation ends up being helpful. If we recognize that we are in a physiological state where the body is not ready for decision making, meditation is nothing more than taking yourself out of the situation for the five, ten or fifteen minutes that it takes for your body/mind wiring to reset, and slowly reduce the level of stress hormones back to levels at which you make make better decisions. Perhaps this is why Ray Dalio subsidizes meditation classes at Bridgewater, and why there has been a recent wave of “mindfulness” classes at trading desks across Wall Street and in popular media (the picture below is from a checkout counter at Barnes and Noble).

Mindfulness becomes mainstream as a stress reliever

You have also probably observed a troubling natural response to dealing with stress at work, or at home. Researcher Robert Sapolsky observed that the natural approach amongst primates to reducing levels of cortisol or stress hormones was biting subordinates. Unfortunately, we can observe this behavior in ourselves, where we tend to snap more at others when we are stressed.

Understanding neurology can help identify ways to deal with stress that can improve wellness as well as our ability to make better decisions. This understanding also complements and corroborates behavioral finance theories put forth by the likes of Dan Kahneman.

Further reading:

Also published on Medium.