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 Remember how you felt after weeks and weeks of the financial crisis
in 2008?
That was probably the stress hormone cortisol talking and it was
working hard to shift how you experience risk.
How you manage that can be key to your success as an investor.
Understanding how cortisol can affect investors and the market as a
whole can be key to figuring out what happens next.
A March study by nine British and Australian academics published in
the September edition of the Proceedings of the National Academy of
Sciences of the United States of America found that prolonged
exposure to cortisol can increase risk aversion.
In contrast, a one-off acute increase in cortisol didn’t have much
impact on attitudes toward risk.
In other words, hit one bump in the road and you will tend to
maintain speed; hit a bunch of bumps and you tend to slow down.
“We have found that an acute elevation of cortisol has no
significant effect on financial risk taking whereas a sustained
elevation leads to greater risk aversion, with study participants
preferring lower expected return and lower-variance bets,” the
authors write.
Much of this will be intuitive to close observers of financial
markets. During bear markets, when future returns are in theory
increasing, investors are less and less willing to take on risk.
During bull markets, the higher the prices, the more willing to take
risks investors seem to be.
Cortisol is known to increase when people are put in new, uncertain
conditions or those they clearly cannot control.
An earlier study by the group, of London-based financial traders,
found that as volatility increased over an eight-day period the mean
cortisol level of the subject shot up by 68 percent.
So if volatility makes cortisol rise what happens to risk appetite
when it does?
This study dosed volunteers with varying amounts of cortisol or
placebos and then had them play computer games to gauge risk
appetite.
“Our findings point to an alternative model of risk taking. In it
risk preferences are not stable; rather, they are highly dynamic.
Such a model might help explain why the risk premium on equities
rises and falls with volatility, and why the appetite for risk among
the financial community seems to expand during a rising market, and
contract during a declining one,” the authors write.
MASTERING YOURSELF, OBSERVING OTHERS
This rather implies that investors, who as a species tend to buy and
sell at more or less the wrong time, need to accept that they will
have these feelings and develop strategies to make sure they are not
overly influenced by them.
One way is simple awareness, another is by delegating investment
decisions to third parties, preferably institutions with a better
chance of operating within frameworks that discourage chemically
driven buying and selling.
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The study says very little about bull markets and how to avoid the
possibly chemically generated mistakes they engender.
From a more macro point of view this is an obvious, though again not
counter-intuitive, lesson for policy makers. Global central bankers
seem to have learned well the lesson that acute and long financial
events require shock therapy to avert panic selling. What policy
makers seem less good at is returning to neutral.
As for the current bout of market volatility, it is uncertain if it
has gone on long enough to make a lasting change in investors' risk
appetites. In China surely, in the U.S. perhaps.
“One-off stress events won’t drive dynamic risk aversion. We need a
sustained period of stress and chaos to change hearts and minds,”
Wesley R. Grey, chief investment officer of asset allocation and
investment firm Alpha Architect wrote in a note to clients.
“The recent turmoil in August, and now into September, may not be
enough sustained stress to change minds, but if the drama continues
... watch out!”
It really is genuinely difficult to know what exactly the chemical
mindset of the market is right now. On the one hand clearly we’ve
had a decent period of higher volatility. But this is after an
extended period of very low volatility, almost certainly due to
monetary policy.
It would be interesting to see what happens to cortisol levels
around the possible interest rate rise by the Federal Reserve next
week.
At this point a jolt of risk aversion from the Fed may have a big
impact.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may bean
owner indirectly as an investor in a fund. You can email him at
jamessaft@jamessaft.com and find more columns at http://blogs.reuters.com/james-saft)
(Editing by James Dalgleish)
(James Saft is a Reuters columnist. The opinions expressed are his
own)
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