Of greed and mayhem

The Hour Between Dog and Wolf: Risk Taking, Gut Feelings and the Biology of Boom and Bust, by John Coates

DUSK, in medieval times, was the hour between dog and wolf, a time when we could not easily distinguish one from the other. There was a pervasive fear that the dog you knew could become a wolf.

Author John Coates worked on Wall Street in the 1990s, trading derivatives for Goldman Sachs, then Merrill Lynch, and finally running a desk for Deutsche Bank.

During this time, the Nasdaq rose from 600 to a peak of just over 5,000! This spectacular rise was unsupported by any hard financial data. Translated into non-trading terms, that means the growth was based on a widely accepted delusion.

The economist John Maynard Keynes noted in the 1930s that markets could remain irrational longer than investors could remain solvent. In 2000 the Nasdaq collapsed, dropping more than 3,000 points in about a year.

“While they last, (market) bubbles are fun,” notes Coates. During this period, he observed traders turn from dog to wolf. Investors, egged on by traders, were putting money into companies with inexplicable business models, in internet industries they did not understand.

Coates noted at the time that it was almost impossible to engage in a reasoned discussion with either the owner or the investors.

According to folk wisdom, behind this type of mayhem lies overwhelming greed. It leaves no place for the sober thought that what cannot last, will not last.

Coates observed traders moving from assessing risk and making professional judgement accordingly, to believing that they knew what was going to happen. 

He observed: "... they even walk differently: more erect, more purposeful, their very bearing carrying a hint of danger: 'Don’t mess with me,' their bodies seem to say. 'I can handle anything'."

Their behaviour caught Coates' attention during the dot.com era. It was undeniable that people were changing. Traders were slowly becoming euphoric and delusional. They were placing ever larger bets on ever worsening risk-reward trade-offs.

This type of behaviour has been identified in other areas, particularly politics. Lord David Owen, a former British foreign secretary, a neurologist by training, called the disorder the Hubris Syndrome. It is characterised by "recklessness, an inattention to detail, overwhelming self-confidence, and contempt for others".

What struck Coates at the time was the relative immunity of women to this frenzy.

Some have suggested that the mood was driven by the use of cocaine, but the extent of drug use was wildly exaggerated. Coates became convinced that we should be looking at traders’ biology.

He hypothesised that the extreme overconfidence and risk-taking displayed during bubbles may be a chemically induced pathological behaviour. This could explain the difference between male and female responses. 

Coates retired from Wall Street and returned to the University of Cambridge, where he had earned his Ph D in economics, and spent the next four years retraining in neuroscience and endocrinology. He designed experiments to test the hypothesis that the “winner effect” exists in the financial markets.

The “winner effect” has been identified in animals who have won fights, and then go on to riskier fights with even higher testosterone levels. A similar phenomenon can be observed in sportsmen.

Through observation and experiments, Coates and others have been able to identify how our physiology actually determines - and not simply affects - behaviour.

This is a powerful and counterintuitive insight. In the West we have been raised on the notion that our brains control our bodies, but reliable science is fast showing the reality is just the opposite.

Kehaneman and Twersky studied the effects of behaviour on economics throughout the 20th century and won a Nobel Prize for their work.

They showed, put simply, how economics is not a function of rational man making rational decisions, but rather that our minds affect our economic decisions in ways we are unaware. Coates highlights the step beyond this – our bodies actually control our thinking in ways we are unaware.

Consider a cricket fielder at silly mid-on, a position extremely close to the batsman. The ball leaving the bat can travel at speeds of up to 160 kilometres an hour. Crouched 4 metres from the batsman, the fielder does not have enough time to register the trajectory of the ball consciously.

His reaction to this lethal projectile occurs in 90 milliseconds. The body does the thinking before the mind knows.

The speed here is similar to the speed at which decisions have to be made in trading and investment. There is no time for a thorough analysis and research. Many well-known investors, including George Soros, admit being guided, in part, by physiological responses to positions. Soros reports that he used the onset of acute back pain as a signal that there was something wrong with his portfolio.

The notion of “gut feeling” implies that in even the most complex mental tasks, such as understanding the stock market, our bodies are giving guidance. Knowing when to take the guidance and when to ignore it is not a simple matter. It is here that knowledge and experience come into play. 

Our bodies have evolved over centuries to respond to physical risks. Financial risk carries a similar threat, not of risk to life but certainly of risk to lifestyle and social status. Little wonder that the chemical or hormonal responses are similar.

Much has already been learned about dealing with stress situation from sports science. There is evidence that just as physical toughness can be developed to peak levels as seen in world class athletes, so too can mental toughness.

This toughness would allow people in high stress, fast-paced business environments to function more effectively.

That would be very useful.

Readability:   Light ----+ Serious
Insights:       High +---- Low
Practical:      High ---+- Low

 - Fin24

* Ian Mann of Gateways consults internationally on leadership and strategy. Views expressed are his own.   
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