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Author: rclosch Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 212573  
Subject: The Chemistry of Risk Date: 8/7/2012 3:42 PM
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The best measure of the markets current irrationality can be found in short-dated government security markets. Currently investors are egger to hand over money in exchange for sovereign debt yielding less than nothing. At the end of last week, two year obligations of the governments of Austria, Denmark, Finland, Germany, the Netherlands, and Sweden all were yielding less than zero. Whereas, Berkshire Hathaway with less “real” long term risk than most Government credits (in my opinion) offers an earnings yield of 6.3% if include look-through earnings. So that the current insanity verges on a safety bubble, and displays mild flavor of panic.

The market may be efficient but it is certainly not rational, and in this sense, the market is very efficient at measuring Wall Street’s current mania whatever it may be. Whatever the market is measuring, it is certainly not the intrinsic value of the stocks being traded. In 1982, the PE of the S&P was 9. Then, this PE began to gradually increase until, by 2000, it was 34. From the peak in 2000 it has decreased until today it is around 13. During this entire period Corporate Profits, ignoring the occasional recession, have increased at fairly constant rate of about 8% per year. An efficient market should reflect this steady growth in earnings, but the actual market does nothing of the kind. What we get instead is a steadily changing view of the value of corporate earnings.

Testosterone

Additional evidence of an irrational link between human behavior and the markets is provided by John Coates in his new book “The Hour between Dog and Wolf”. A successful trader first at Goldman Sachs then then at Merrill Lynch and Deutsch Bank in the eighties and early nineties Coates returned to Cambridge to do research in neuroscience. His time on the trading floor got him interested the effects of steroids on traders’ behavior. He now suspects there may be a chemical solution for the riddle of Mr. Market’s psychosis, and a biological basis for his behavioral problems. The laws of financial boom and bust, he maintains, have more than a little to do with male hormones.

In a series of experiments that he conducted on the trading floor of a large London firm, Dr. John Coates tested the testosterone level of traders in the morning as they showed up for work and found that traders with high testosterone made more profit during the day than those with low levels. Dr. John Coates identified a feedback loop between testosterone and success that dramatically lowers the fear of risk in men, especially younger men. This loop builds on success because successful trades lead to higher testosterone and acceptance of bigger trading risk.

The book moves on to a detailed look at nature human hormones and the effects of our chemistry on our behavior. Success fuels testosterone levels so that in a bull market traders are encouraged by their chemistry to take on more and more risk, a process I suspect is intensified by the huge bonuses paid to traders in large banks and brokerage companies. This process that can continue to build over many years as bonuses get bigger and bigger, and eventually the bull market turns into a mania.

Clearly, we cannot blame testosterone for all of the collective insanity of the subprime mess but it probably helped-- the $40 million bonuses and salaries for traders and $100 million plus compensation for CEO’s helps to build testosterone levels, and tend to make humans think there are a lot smarter than they really are.

Cortisol

Another Steroid that effects trader behavior is cortisol otherwise as known as the stress hormone or the antitestosterone hormone. It has the opposite effect on trader’s behavior, lowering the appetite for risk across an entire spectrum of decisions. Trading failure leads to a rise in levels of cortisol so that this hormone rules the bear market, and seems to have firm control of Mr. Market today. Cortisol can build if bad trades continue for a long period to the point that the trader essentially becomes unable to initiate a new position.

The laws of financial boom and bust, it turns out, may have more than a little to do with male hormones, but hormones clearly only part of the markets underlying irrationality. Coates set out to explain patterns of behavior that observed in his previous life on the trading floor, and his research offers valuable insights into the exploding new field—the biology of risk.

Traders (whether they are individuals, money managers or institutional investors) place their bets and live with the results. Coates finds biology tends to drive them to irrational exuberance and then an equally irrational pessimism. Risk concentrates the mind—and the body—like nothing else, altering our physiology in ways that have profound and lasting effects. What's more, biology shifts investors' risk preferences across the business cycle and can precipitate high volatility in the marketplace.
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