How do we react during times of financial stress? At this year’s Lipper Alpha Forum, guests explored the influence of human behavior in risk taking.
A creature called the sea squirt demonstrates that the brain is there predominantly to plan and execute action, rather than to engage in deep and meaningful thoughts.
For when the sea squirt reaches its attachment place, it eats its own brain. The creature no longer needs it for movement and instead uses the material to develop other, more necessary organs.
Human brains are bigger than other animals’ because of the more sophisticated and complex movements we exhibit. How humans react to risk and stress, and how we handle extended periods of both, weigh heavily on our decision-making tendencies.
Who better than a former Wall Street trader turned neuroscientist and behavioral expert to explain how this works in the context of financial investing and risk taking?
Dr. John Coates — the keynote speaker at this year’s Lipper Alpha Forum in New York — is a former senior fellow at the University of Cambridge, where he led research on the biology of risk, and is author of The Hour Between Dog and Wolf. He was previously a Goldman Sachs derivatives trader.
Changing risk tolerances
Dr. Coates explained to our Lipper Alpha Forum audience that stress (and the hormone cortisol) is our body’s way to physically prepare for movement during risk — not some psychological affair.
By understanding the implications of the physiological and focusing less on the psychological, stress and the resulting biological reactions to risk are better understood.
Investment decisions are not a purely intellectual affair.
Dr. Coates argues that most risk management tools — much like modern portfolio theory — get human behavioral tendencies wrong.
Risk assessment models generally believe in a steady, consistent state of risk tolerance from humans, when in fact our tolerances change as an event goes from short term to long term.
Tendencies during short periods of stress include the desire to act, to do something — anything — because the body has received this surge in electricity and chemical information; our brain and hormones prepare us to act.
As the stressful period elongates (such as with a market downturn), the body begins to wear down from its state of preparedness and risk tolerances change.
“Irrational exuberance or pessimism” following investment decisions can “destabilize the financial markets and wreak havoc on the wider economy”, Dr. Coates writes in his book The Hour Between Dog and Wolf.
During the 2008 financial crisis, instances occurred where traders became paralyzed with fear. Unwilling to execute even what appeared to be the safest of trades, they were terrified they would be wrong and the investment would fail.
Traders had become so risk averse, their tolerance for risk was essentially zero.
The physical toll of this stress and risk aversion resulted in devastating consequences, including increased reports of heart attacks.
Movement is critical to our survival.
Dr. Coates referenced studies that have demonstrated how the brain is most creative, efficient and plastic after exercise.
Embrace the physical movement your body craves under the duress of financial risk-taking. As Dr. Coates closed his keynote address he implored: “If you take nothing else away from this, keep moving!”
Investors who harness this knowledge and actively incorporate it into their decision making process can outperform.
So you heard it here, from this year’s Lipper Alpha Forum: our thoughts aren’t as deep and meaningful as we’d like because our brains are primarily for movement.
And we can become better at investing and trading by improving our understanding of our immediate and prolonged reactions to stress and financial risk.