The biology of risk-taking appetite among humans

We do not process information as a computer does, dispassionately; we react to it physically.

Six years after the financial meltdown there is once again talk about market bubbles. Are stocks succumbing to exuberance? Is real estate? We thought we had exorcised these demons. It is therefore with something close to despair that we ask: What is it about risk taking that so eludes our understanding, and our control? Part of the problem is that we tend to view financial risk taking as a purely intellectual activity.

 But this view is incomplete. Risk is more than an intellectual puzzle — it is a profoundly physical experience, and it involves your body. Risk by its very nature threatens to hurt you, so when confronted by it your body and brain, under the influence of the stress response, unite as a single functioning unit. This occurs in athletes and soldiers, and it occurs as well in traders and people investing from home. The state of your body predicts your appetite for financial risk just as it predicts an athlete’s performance.

If we understand how a person’s body influences risk taking, we can learn how to better manage risk takers. We can also recognise that mistakes governments have made have contributed to excessive risk taking. 

Consider the most important risk manager of them all — the Federal Reserve. Over the past 20 years, the Fed has pioneered a new technique of influencing Wall Street. Where before the Fed shrouded its activities in secrecy, it now informs the street in as clear terms as possible of what it intends to do with short-term interest rates, and when. Janet L Yellen, the chairwoman of the Fed, declared this new transparency, called forward guidance, a revolution; Ben S Bernanke, her predecessor, claimed it reduced uncertainty and calmed the markets. But does it really calm the markets? Or has eliminating uncertainty in policy spread complacency among the financial community and actually helped inflate market bubbles? 

We get a fascinating answer to these questions if we turn from economics and look into the biology of risk taking. One biological mechanism, the stress response, exerts an especially powerful influence on risk taking. We live with stress daily, especially at work, yet few people truly understand what it is. Most of us tend to believe that stress is largely a psychological phenomenon, a state of being upset because something nasty has happened. But if you want to understand stress you must disabuse yourself of that view. The stress response is largely physical: It is your body priming itself for impending movement.

As such, most stress is not, well, stressful. For example, when you walk to the coffee room at work, your muscles need fuel, so the stress hormones adrenaline and cortisol recruit glucose from your liver and muscles; you need oxygen to burn this fuel, so your breathing increases ever so slightly; and you need to deliver this fuel and oxygen to cells throughout your body, so your heart gently speeds up and blood pressure increases. This suite of physical reactions forms the core of the stress response, and, as you can see, there is nothing nasty about it at all.

Far from it. Many forms of stress, like playing sports, trading the markets, even watching an action movie, are highly enjoyable. In moderate amounts, we get a rush from stress, we thrive on risk taking. In fact, the stress response is such a healthy part of our lives that we should stop calling it stress at all and call it, say, the challenge response.

The challenge response

This mechanism hums along, anticipating challenges, keeping us alive, and it usually does so without breaking the surface of consciousness. We take in information nonstop and our brain silently, behind the scenes, figures out what movement might be needed and then prepares our body. Many neuroscientists now believe our brain is designed primarily to plan and execute movement, that every piece of information we take in, every thought we think, comes coupled with some pattern of physical arousal. We do not process information as a computer does, dispassionately; we react to it physically. For humans, there is no pure thought of the kind glorified by Plato, Descartes and classical economics.

Uncertainty over the timing of something unpleasant often causes a greater challenge response than the unpleasant thing itself. Sometimes it is more stressful not knowing when or if you are going to be fired than actually being fired. Why? Because the challenge response, like any good defence mechanism, anticipates; it is a metabolic preparation for the unknown.

In one of my studies, conducted with 17 traders on a trading floor in London, we found that their cortisol levels rose 68 per cent over an eight-day period as volatility increased. Subsequent, as yet unpublished, studies suggest to us that this cortisol response to volatility is common in the financial community. A question then arose: Does this cortisol response affect a person’s risk taking? In a follow-up study, my colleagues from the department of medicine pharmacologically raised the cortisol levels of a group of 36 volunteers by a similar 69 percent over eight days. We gauged their risk appetite by means of a computerized gambling task. The results, published recently in the Proceedings of the National Academy of Sciences, showed that the volunteers’ appetite for risk fell 44 per cent.

When opportunities abound, a potent cocktail of dopamine — a neurotransmitter operating along the pleasure pathways of the brain — and testosterone encourages us to expand our risk taking, a physical transformation I refer to as “the hour between dog and wolf.” One such opportunity is a brief spike in market volatility, for this presents a chance to make money. But if volatility rises for a long period, the prolonged uncertainty leads us to subconsciously conclude that we no longer understand what is happening and then cortisol scales back our risk taking. In this way our risk taking calibrates to the amount of uncertainty and threat in the environment.

Under conditions of extreme volatility, such as a crisis, traders, investors and indeed whole companies can freeze up in risk aversion, and this helps push a bear market into a crash. Unfortunately, this risk aversion occurs at just the wrong time, for these crises are precisely when markets offer the most attractive opportunities, and when the economy most needs people to take risks. The real challenge for Wall Street, I now believe, is not so much fear and greed as it is these silent and large shifts in risk appetite.

IT may seem counterintuitive to use uncertainty to quell volatility. But a small amount of uncertainty surrounding short-term interest rates may act much like a vaccine immunizing the stock market against bubbles. More generally, if we view humans as embodied brains instead of disembodied minds, we can see that the risk-taking pathologies found in traders also lead chief executives, trial lawyers, oil executives and others to swing from excessive and ill-conceived risks to petrified risk aversion.
 It will also teach us to manage these risk takers, much as sport physiologists manage athletes, to stabilize their risk taking and to lower stress.