Financial traders' stress hormones soar in periods of sustained market volatility, making them vulnerable to "irrational pessimism" and potentially contributing to market crises, a new study says.
Front-line market players show risk-averse behaviour at precisely the time when they should be taking risks – when markets are crashing and the economy needs traders and investors to buy distressed assets, according to the research paper's findings, published Monday.
Increases in cortisol – a stress hormone – appear to play a key role in shutting down the appetite for risk, said Wall Street trader-turned-neuroscientist John Coates, the study's co-lead from the Cambridge Judge Business School.
Yet traders, their managers and firms as well as central banks and regulators have little understanding of the role physiology plays during periods of high volatility and uncertainty, said Dr. Coates, a former senior derivatives trader at Goldman Sachs and Deutsche Bank.
"It is frightening to realize that no one in the financial world knows that these subterranean shifts in risk appetite are taking place," he said in an interview.
The study, published in Proceedings of the National Academy of Sciences, is based on research that found cortisol levels among City of London traders rose 68 per cent over a two-week period of heightened market volatility.
In a subsequent lab study, 36 volunteers were administered hydrocortisone – the pharmaceutical version of cortisol – over an eight-day period, raising their cortisol levels 69 per cent. The volunteers then took part in lottery-style financial risk-taking tasks and there was a dramatic drop in their willingness to take risks, according to the report.
Dr. Coates and his team indicate that volatility in U.S. equities jumped to over 70 per cent from 12 per cent during the global credit crisis of 2007 to 2009.
Chronic stress of this magnitude may have dialled down risk taking just when it was most required, they say.
"It seems reasonable to assume that such historically high levels of uncertainty would have caused stress hormones to rise substantially, and for a much longer period than we observed in our study," the paper says.
The findings overturn the widely held theory that personal risk preference is a stable trait, Dr. Coates says.
"You can be dangerously stressed without being aware of it. Central banks haven't got a clue as to how to deal with this."
One way to address the problem would be to allow traders to use technology and tests to regularly monitor their stress hormones, said the Montreal-born Dr. Coates, who worked for about a year on Goldman Sachs' derivatives trading desk in Toronto.