* Stress may be under-recognised cause of market instability
* Findings are from field and lab studies of cortisol levels
* Stress levels shot up during increased market volatility
By Kate Kelland
LONDON, Feb 17 Financial markets may be more
vulnerable to traders' stress levels than previously thought,
according to a scientific study which found that high levels of
the stress hormone cortisol can induce risk aversion.
The findings, which turns on its head the assumption that
traders appetite for risk-taking remains constant throughout
market up and downs, suggests stress could in fact make them
more cautious, exacerbating financial crises just at a time when
risk-taking is needed to support crashing markets.
In a study of City of London traders and of the effect of
cortisol on behaviour, researchers led by Dr John Coates - a
former Goldman Sachs and Deutsche Bank derivatives trader turned
neuroscientist - said this tendency towards caution could be an
"under-appreciated" cause of market instability.
Coates also said the finding could alter our understanding
of risk - since up until now, financial and economic models have
largely rested on the assumption that traders' personal risk
preferences are consistent throughout the market cycle.
"Any trader knows that their body is taken on a roller
coaster ride by the markets. What we haven't known until this
study was that these physiological changes - the sub-clinical
levels of stress of which we are only dimly aware - are actually
altering our ability to take risks," said Coates, now a
researcher in neuroscience and finance at Cambridge University.
"It's frightening to realise that no one in the financial
world - not the traders, not the risk managers, not the central
bankers - knows that these subterranean shifts in risk appetite
are taking place."
Coates team based this study on the findings of previous
research conducted with traders in the City of London, which
found that cortisol levels rose by 68 percent over a two week
period when market volatility increased.
Combining that field work with a laboratory study, they gave
hydrocortisone, the pharmaceutical form of cortisol, to 36 male
and female volunteers aged between 20 and 36 over eight days to
test the effects of raised cortisol on financial risk-taking.
The volunteers' cortisol levels were upped by 69 percent -
almost exactly the levels seen in the traders. They were then
asked to undertake a series of financial risk-taking tasks with
real monetary pay-offs, designed to measure their risk appetite
and the probability judgment driving their risk taking.
In a report of their findings in the Proceedings of the
National Academy of Sciences (PNAS) journal, Coates' team found
that initial spikes in cortisol had little effect on behaviour.
But chronically high and sustained levels, as seen in
traders in the field study, led to a dramatic drop in
willingness to take risks, with the "risk premium" - the amount
of extra risk someone will tolerate for the possibility of
higher return - falling by 44 percent.
"Many influential models in economics, finance and
neurobiology assume risk preferences are a stable trait, but we
find they are not," the researchers wrote.
The team noted that during the credit crisis of 2007 to
2009, volatility in U.S. equities spiked from 12 percent to more
than 70 percent.
They argued that such historically high levels of
uncertainty could have caused cortisol levels to rise far higher
and for longer than this study analysed, and therefore that
chronic stress may have reduced risk taking just when the
economy needed it most - when markets were crashing and needed
traders and investors to buy risky assets.
"Traders, risk managers, and central banks cannot hope to
manage risk if they do not understand that the drivers of risk
taking lurk deep in our bodies," Coates said. "Risk managers who
fail to understand this will have as little success."