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11 September 2017 Financial Analysts Journal Book Review

The Hour between Dog and Wolf: Risk Taking, Gut Feelings, and the Biology of Boom and Bust (a review)

  1. Mark K. Bhasin, CFA
The author offers a number of fascinating lessons from a booming new field, the biology of risk, revealing how risk taking and stress transform our body chemistry and drive us to irrational exuberance or pessimism. When such chemical surges overwhelm traders and investors, they tend to suffer either euphoric overconfidence or extreme timidity.

John Coates, senior research fellow in neuroscience and finance at the University of Cambridge, offers a number of fascinating lessons from a booming new field, the biology of risk, in The Hour between Dog and Wolf: Risk Taking, Gut Feelings, and the Biology of Boom and Bust. He reveals how risk taking and stress transform our body chemistry, driving us to irrational exuberance or pessimism. He asserts that under some circumstances, the chemical surges can overwhelm us, and when that happens to traders and investors, they tend to suffer either euphoric overconfidence or extreme timidity. Coates contends that these extremes can destabilize the financial markets and wreak havoc on the wider economy. In this reviewer’s opinion, it is reasonable to conclude that this overconfidence could contribute significantly to market bubbles. Conversely, it is also reasonable to conclude that traders and investors may exhibit such timidity and excessive pessimism that they elect to remain on the sidelines despite appealing valuations during severe market declines. These two effects have a destabilizing impact on asset prices and financial markets.

Coates, who once headed a derivatives trading desk, focuses on the moment of Jekyll-and-Hyde transformation that traders pass through when under pressure. This moment of transformation, which the French have called “the hour between dog and wolf” since the Middle Ages, results from rising levels of testosterone that increase both one’s self-confidence and, crucially, one’s appetite for risk.

According to Coates, traders and investors become cocky and irrationally risk seeking when on a winning streak but tentative and risk averse when recovering from losses. Coates discusses the “winner effect,” a model borrowed from the study of animal behavior, which offers an explanation of trader behavior during market bubbles. This model suggests that winners in battle emerge with heightened levels of testosterone and the losers, with reduced levels. If the winners proceed to a further round of competition, they do so with already elevated testosterone, and this androgenic1 priming gives them an edge that helps them win again. As testosterone levels continue rising, self-confidence and risk taking segue into overconfidence and reckless behavior.

Coates argues that the winner effect is a plausible explanation for the chemical hit that traders receive, one that exaggerates a bull market and turns it into a bubble. In this reviewer’s opinion, the winner effect could partly explain the overconfidence exhibited by traders and investors during the formation of market bubbles. The role of testosterone could also explain why women appeared relatively unaffected by recent bubbles—they have about 10–20% of the testosterone levels of men. Conversely, Coates discusses traders’ susceptibility to “learned helplessness,” a condition in which they completely lose faith in their ability to control their own fates. When intensity is replaced by resignation, withdrawal, and depression, chances are the individual has succumbed to learned helplessness. Painful failure leads to a rise in the levels of cortisol, the stress hormone that lowers the appetite for risk across the entire spectrum of decisions.

Researchers have identified three types of situations that signal a threat and elicit a massive physiological stress response—those characterized by novelty, uncertainty, or uncontrollability. Coates explores how traders can train their physiology in order to increase their mental and physical stamina, toughening themselves against the fatigue, anxiety, and psychiatric disorders that follow from chronic stress.

Sports scientists have made remarkable breakthroughs in designing such toughening regimes. They have found that the process of mental toughening bears similarities to that of physical toughening. One of the first discoveries was that when subjects were exposed to chronic (or unrelenting) stress, they began to suffer both physical illness and learned helplessness. However, exposure to acute (or short-lived) stress, even if repeated over and over, produced a tougher physiology and an increased immunity to the damaging effects of further stressors.

Sports scientists know that to build lean-muscle mass and expand aerobic capacity, athletes must endure a training process that shocks their muscles and taxes their cardiovascular systems, to the point of inflicting mild damage on tissues, punctuated with periods of rest and recovery. Alternating sequences of stress and recovery—when calibrated to exhaust (just barely) an athlete’s resources and then replenish them—can expand the productive capacity of a broad range of cells in the athlete’s body. Scientists studying mental toughening have found that a similar process of challenge and psychological loading, followed by recovery, can tune the brain and nervous system such that the subject can approach stressors with resilience and an optimal mix of hormones and nervous system activation.

The author contends (correctly, in this reviewer’s opinion) that investment organizations can defuse the explosive mix of hormones and risk taking by promoting biological diversity—specifically, by hiring more women and older men. Men’s testosterone levels rise until their mid-20s and then go into a slow decline that accelerates after the age of 50. At the same time, the levels of cortisol (the stress hormone) drift upward. As men age, they become less susceptible to the testosterone feedback loops that can cause normal risk taking to morph into risky behavior. There is little evidence that age impairs either investors’ judgment or their ability to take risk. In fact, most legendary investors, such as Warren Buffett and Benjamin Graham, achieved their eminent status at a later stage in their lives, not as young men. Women, for their part, have a biology that is very different from that of men. As noted earlier, they produce, on average, about 10–20% as much testosterone as men and are thus less prone to the winner effect than are young males.

Coates refutes the general perception that women are more risk averse than men. He cites a study by Brad Barber and Terrance Odean that analyzed 35,000 personal accounts over 1991–1997 that showed single women outperformed single men by nearly 1.5%. This outperformance could be correlated with greater risk taking by women. Some researchers have traced this outperformance to the fact that women traded their accounts less frequently than men, who tended to overtrade their accounts owing to overconfidence. Coates offers a different explanation of women’s outperformance: Women compose only about 5% of an average bank trading floor but as much as 60% of the employees of major U.K. asset management companies. Although asset management involves risk taking, it is a different style of risk taking from the high-frequency variety so prevalent at banks. Coates suggests that the difference between men’s and women’s risk taking may lie not so much in different levels of risk aversion as in the length of time the two sexes take to make decisions. He argues that the financial world needs more long-term strategic thinking, and the data indicate that women excel at this activity. Coates makes a very convincing argument that a financial community with a more even balance between men and women, young and old, would be a significant improvement over the current system.

The Hour between Dog and Wolf cogently argues that through biology-based techniques, traders can increase their self-awareness and develop much-needed skill in interpreting and controlling their exuberance, fatigue, anxiety, and stress. Handling risk and its attendant stress is a matter of mind and body working together. Coates urges, “Know thyself,” which today increasingly means knowing your biochemistry.


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