̽��ֱ�� of Cambridge - John Coates

‘Gut feelings’ help make more successful financial traders

cjb250 — Mon, 19 Sep 2016 09:00:00 +0000

‘Gut feelings’ – known technically as interoceptive sensations – are sensations that carry information to the brain from many tissues of the body, including the heart and lungs, as well as the gut. They can report anything from body temperature to breathlessness, racing heart, fullness from the gut, bladder and bowel, and they underpin states such as hunger, thirst, pain, and anxiety.

We are often not conscious – or at least barely aware – of this information, but it provides valuable inputs in risky decision making. High-risk choices are accompanied by rapid and subtle physiological changes that feed back to the brain, affecting our decisions, and steering us away from gambles that are likely to lead to loss and towards those that are likely to lead to profit. This can enable people to make important decisions even before they are able to articulate the reasons for their choices.

Traders and investors in the financial markets frequently talk of the importance of gut feelings for selecting profitable trades. To find out the extent to which this belief is correct, researchers from the Universities of Cambridge and Sussex in the UK and Queensland ̽��ֱ�� of Technology in Australia compared the interoceptive abilities of financial traders against those of non-trader control subjects. Their results are published today in the journal Scientific Reports.

̽��ֱ��researchers recruited 18 male traders from a hedge fund engaged in high frequency trading, which involves buying and selling futures contracts for only a short period of time – seconds or minutes, a few hours at the most. This form of trading requires an ability to assimilate large amounts of information flowing through news feeds, to rapidly recognize price patterns, and to make large and risky decisions with split-second timing. This niche of the financial markets is particularly unforgiving: while successful traders may earn in excess of £10 million per year, unprofitable ones do not survive for long.

̽��ֱ��study took place during a particularly volatile period – the Eurozone crisis – so the performance of each trader reflected his ability to make money during periods of extreme uncertainty. ̽��ֱ��researchers measured individual differences in each trader’s capacity to detect subtle changes in the physiological state of their bodies by means of two established heartbeat detection tasks. These tasks test how accurately a person, when at rest, can count their heartbeats. Each trader was given a score which, essentially, measured the percentage of right answers, and these scores were compared against data from 48 students at the ̽��ֱ�� of Sussex.

̽��ֱ��researchers found that traders performed significantly better at the heart rate detection tasks compared to the controls: the mean score for traders was 78.2, compared to 66.9 for the controls. Even within the group of traders, those who were better at the heart rate detection tasks also performed better at trading, generating greater profits.

Strikingly, an individual’s interoceptive ability could be used to predict whether they would survive in the financial markets. ̽��ֱ��researchers plotted heartbeat detection scores against years of experience in the financial markets and found that a trader’s heartbeat counting score predicted the number of years he had survived as a trader.

“Traders in the financial world often speak of the importance of gut feelings for choosing profitable trades – they select from a range of possible trades the one that just ‘feels right’,” says Dr John Coates, a former research fellow in neuroscience and finance at the ̽��ֱ�� of Cambridge, who also used to run a trading desk on Wall Street. “Our findings suggest they’re right – they manage to read real and valuable physiological trading signals, even if they are unaware they are doing so.”

Although the results are consistent with recent studies showing that heartbeat detection skills predict more effective risk taking, the researchers caution that there may be other interpretations. For example, one study has found that heartbeat detection ability increases during stress, so it could be argued that heartbeat detection skills correlated with years of survival merely because experienced traders, taking larger risks, are subjected to greater stresses. ̽��ֱ��authors of the current study think this unlikely – in trading, as in many other professions, experienced and successful individuals, being more in control, are commonly less stressed than beginners.

̽��ֱ��findings also appear to contradict the influential ‘Efficient Markets Hypothesis’ of economic theory, which argues that the market is random, meaning that no trait or skill of an investor or trader – not their IQ, education, nor training – can improve their performance, any more than these traits and skills could improve their performance at flipping coins.

“A large part of a trader’s success and survival seems to be linked to their physiology. Such a finding has profound implications for how we understand financial markets,” adds Dr Mark Gurnell from the Wellcome Trust-Medical Research Council Institute of Metabolic Science at the ̽��ֱ�� of Cambridge.

“In economics and finance most models analyse conscious reasoning and are based on psychology,” Dr Coates continues. “We’re looking instead at risk takers’ physiology – how good are they at sensing signals from their viscera? We should refocus on the body, or more exactly the interaction between body and brain. Medics find this obvious; economists don't.”

̽��ֱ��research was largely funded by the Economic and Social Research Council, the European Research Council and the Dr Mortimer and Theresa Sackler Foundation. Additional support was provided by the National Institute for Health Research Cambridge Biomedical Research Centre.

Reference
Kandasamy, N, Garfinkel, SN, Page, L et al. Interoceptive Ability Predicts Survival on a London Trading Floor. Scientific Reports; 19 Sept 2016; DOI: 10.1038/srep32986

Financial traders are better at reading their ‘gut feelings’ than the general population – and the better they are at this ability, the more successful they are as traders, according to new research led by the ̽��ֱ�� of Cambridge.

In economics and finance most models analyse conscious reasoning and are based on psychology. We should refocus on the body, or more exactly the interaction between body and brain. Medics find this obvious; economists don't

John Coates

Rafael Matsunaga

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Stress hormones in financial traders may trigger ‘risk aversion’ and contribute to market crises

fpjl2 — Tue, 18 Feb 2014 09:27:09 +0000

High levels of the stress hormone cortisol may contribute to the risk aversion and ‘irrational pessimism’ found among bankers and fund managers during financial crises, according to a new study.

̽��ֱ��study’s authors say that risk takers in the financial world exhibit risk averse behaviour during periods of extreme market volatility – just when a crashing market most needs them to take risks – and that this change in their appetite for risk may be “physiologically-driven”, specifically by the body’s response to cortisol. They suggest that stress could be an “under-appreciated” cause of market instability.

Published today in the journal Proceedings of the National Academy of Sciences, the study conducted at the Cambridge Judge Business School and the ̽��ֱ��’s Institute of Metabolic Science is the first to show that personal financial risk preferences fluctuate substantially, and these fluctuations may be linked to hormone response.

̽��ֱ��finding could fundamentally alter our understanding of risk as, up until now, almost every model in finance and economics – even those used by banks and central banks – rested on the assumption that traders’ personal risk preferences stay consistent across the market cycle, say the authors.

In a previous study conducted with real traders in the City of London, researchers observed that cortisol levels rose 68% over a two week period when market volatility increased. In the latest study they combined field work with lab work, a rare approach in economics, to test for the effects of this elevated cortisol on financial risk-taking.

̽��ֱ��researchers administered hydrocortisone – the pharmaceutical form of cortisol – to 36 volunteers, 20 men and 16 women, aged 20 to 36 years, over an eight day period, raising their cortisol levels 69%: almost exactly the levels seen in the traders.

̽��ֱ��volunteers took part in lottery-style financial risk-taking tasks with real monetary pay-offs, designed to measure the preferences for risky gambles and the judgments of probability underlying their risk taking. While initial spikes of cortisol had little effect on behaviour, chronically high and sustained levels, as seen in traders, led to a dramatic drop in participants’ 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%.

“Any trader knows that their body is taken on a rollercoaster 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 risk,” said Dr John Coates, co-lead of the study from the Cambridge Judge Business School, and a former Wall Street derivatives trader himself.

“It is 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.”

Cortisol is a hormone secreted by the adrenal glands in response to moments of high physical stress, such as ‘fight or flight’. Importantly, cortisol also rises powerfully in situations of uncertainty, such as volatility in the financial markets. Cortisol prepares us for possible action by releasing glucose and free fatty acids into the blood. It also suppresses any bodily functions not needed during a crisis - such as the digestive, reproductive, and immune systems.

However, should this stress become chronic, as it might during a prolonged financial crisis, the elevated cortisol can contribute to impaired learning, heightened anxiety, and eventually depression. ̽��ֱ��current study has now shown that in addition to these known pathologies, chronic stress can also lead to a substantial decrease in the willingness to take financial risks, say the researchers.

They also suggest that an unsuspected side effect of anti-inflammatory treatments such as prednisone may be financial risk aversion.

̽��ֱ��study’s authors also looked for differences between men and women. While other researchers have argued that women are more risk averse than men, the current study found no differences between the sexes under normal circumstances. However, the study did find that, when exposed to chronically-raised levels of cortisol, men placed too much importance on smaller risks, while women did not.

̽��ֱ��authors point out that during the Credit Crisis of 2007 to 2009 volatility in US equities spiked from 12% to over 70%. They argue that it is reasonable to assume that such historically high levels of uncertainty would have caused stress hormones to rise far higher and longer than the team had been able to observe in their study.

Chronic stress may therefore have decreased risk taking just when the economy needed it most – when markets were crashing and needed traders and investors to buy distressed assets, they say.

Physiologically-driven shifts in risk preferences may be a source of financial market instability that hasn’t been considered by economists, risk managers and central bankers alike.

Added Coates: “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. Risk managers who fail to understand this will have as little success as fire fighters spraying water at the tips of flames.”

New study’s findings overturn theory of personal risk preference as a ‘stable trait’, and show that real source of instability in risk behaviour “lurks deep in the physiology of traders and investors”.

It is 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

John Coates

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