The Hour Between Dog and Wolf: Risk-taking, Gut Feelings and the Biology of Boom and Bust

JOHN COATES

The Hour Between

Dog and Wolf

Risk-Taking, Gut Feelings

and the Biology of Boom and Bust

Dedication

For Ian, Eamon, Iris and Sarah

Epigraph

[The hour] between dog and wolf, that is, dusk, when the two can’t be distinguished from each other, suggests a lot of other things besides the time of day … The hour in which … every being becomes his own shadow, and thus something other than himself. The hour of metamorphoses, when people half hope, half fear that a dog will become a wolf. The hour that comes down to us from at least as far back as the early Middle Ages, when country people believed that transformation might happen at any moment.

JEAN GENET, PRISONER OF LOVE (1986, TRANS. BARBARA BRAY)

Contents

Cover

Title Page

Dedication

Epigraph

PART I : MIND AND BODY IN THE FINANCIAL MARKETS

Introduction

1 : The Biology of a Market Bubble

2 : Thinking with Your Body

PART II : GUT THINKING

3 : The Speed of Thought

4 : Gut Feelings

PART III : SEASONS OF THE MARKET

5 : The Thrill of the Search

6 : The Fuel of Exuberance

7 : Stress Response on Wall Street

PART IV : RESILIENCE

8 : Toughness

9 : From Molecule to Market

Acknowledgements

Notes

Further Reading

Index

Copyright

About the Publisher

When you take risks, you are reminded in the most insistent manner that you have a body. For risk by its very nature threatens to hurt you. A driver speeding along a winding road, a surfer riding a monster wave as it crests over a coral reef, a mountain climber continuing his ascent despite an approaching blizzard, a soldier sprinting across no-man’s land – each of these people faces a high chance of injury, even death. And that very possibility sharpens the mind and calls forth an overwhelming biological reaction known as the ‘fight-or-flight’ response. In fact, so sensitive is your body to the taking of risk that you can be caught up in this visceral turmoil when death poses no immediate threat. Anyone who plays a sport or watches from the stands knows that even when it is ‘just a game’, risk engages our entire being. Winston Churchill, a hardened campaigner from the most deadly wars, recognised this power of non-lethal risk to grip us, body and mind. When writing of his early years, he tells of a regimental polo match played in southern India that went to a tie-break in the final chukka: ‘Rarely have I seen such strained faces on both sides,’ he recalls. ‘You would not have thought it was a game at all, but a matter of life and death. Far graver crises cause less keen emotion.’

Similar strong emotions and biological reactions can be triggered by another form of non-lethal risk – financial risk-taking. With the exception of the occasional broker suicide (and these may be more myth than reality), professional traders, asset managers and individuals investing from home rarely face death in their dealings. But the bets they place can threaten their job, house, marriage, reputation and social class. In this way money holds a special significance in our lives. It acts as a powerful token distilling many of the threats and opportunities we have faced over eons of evolutionary time, so making and losing it can activate an ancient and powerful physiological response.

In one important respect, financial risk carries even graver consequences than brief physical risk. A change in income or social rank tends to linger, so when we take risks in the financial markets we carry with us for months, even years after our bets have settled, an inner biological storm. We are not built to handle such long-term disturbances to our biochemistry. Our defence reactions were designed to switch on in an emergency and then switch off after a matter of minutes or hours, a few days at the most. But an above-average win or loss in the markets, or an ongoing series of wins or losses, can change us, Jekyll-and-Hyde-like, beyond all recognition. On a winning streak we can become euphoric, and our appetite for risk expands so much that we turn manic, foolhardy and puffed up with self-importance. On a losing streak we struggle with fear, reliving the bad moments over and over, so that stress hormones linger in our brains, promoting a pathological risk-aversion, even depression, and circulate in our blood, contributing to recurrent viral infections, high blood pressure, abdominal fat build-up and gastric ulcers. Financial risk-taking is as much a biological activity, with as many medical consequences, as facing down a grizzly bear.

This statement about biology and the financial markets may sound strange to ears accustomed to the teachings of economics. Economists tend to view the assessment of financial risk as a purely intellectual affair – requiring the calculation of asset returns, probabilities, and the optimal allocation of capital – carried on for the most part rationally. But to this bloodless account of decision-making I want to add some guts. For recent advances in neuroscience and physiology have shown that when we take risk, including financial risk, we do a lot more than just think about it. We prepare for it physically. Our bodies, expecting action, switch on an emergency network of physiological circuitry, and the resulting surge in electrical and chemical activity feeds back on the brain, affecting the way it thinks. In this way body and brain twine as a single entity, united in the face of challenge. Normally this fusion of body and brain provides us with the fast reactions and gut feelings we need for successful risk-taking. But under some circumstances the chemical surges can overwhelm us; and when this happens to traders and investors they come to suffer an irrational exuberance or pessimism that can destabilise the financial markets and wreak havoc on the wider economy.

To give you a mere inkling of how this physiology works, I am going to take you onto the trading floor of a Wall Street investment bank. Here we will observe a high-stakes world where young bankers can step up or down a full social class in the space of a single bonus season, one year buying a beach house in the Hamptons, the next pulling their kids out of private school. So consider if you will the following scenario, in which an unanticipated and important piece of news impacts an unsuspecting trading floor.

INCOMING!

It has been said of war that it consists of long stretches of boredom punctuated by brief periods of terror, and much the same can be said of trading. There are long stretches of time when little more than a trickle of business flows in through the sales desks, perhaps just enough to keep the restless traders occupied and to pay the bills. With no news of any importance coming across the wire, the market slows, the inertia feeding on itself until price movement grinds to a halt. Then, people on a trading floor disappear into their private lives: salespeople chat aimlessly with clients who have become friends, traders use the lull to pay bills, plan their next ski trip, or talk to headhunters, curious to know their value on the open market. Two traders, Logan, who trades mortgage-backed bonds, and Scott, who works down the aisle on the arbitrage desk, toss a tennis ball back and forth, taking care not to hit any salespeople.

This afternoon the Federal Reserve is holding a meeting of its Board of Governors, and normally these events are accompanied by market turbulence. It is at these meetings that the Fed decides whether to raise or lower interest rates, and should it do so it announces its decision at 2.15 p.m. Even though the economy has been growing at a healthy clip and the stock market has been unseasonably, even irrationally, strong, the Fed has dropped few hints of an increase. So today it is widely expected to leave rates unchanged, and by late morning most people across the trading floor haven’t a worry on their minds, and think of little else but whether to order sushi or pasta for lunch.

But just before noon there comes the merest breath of change, rippling the surface of prices. Most people on the floor do not consciously notice it, but the slight tremor registers none the less. Maybe their breathing quickens, maybe muscles tense just a bit, maybe arterial blood pressure increases ever so slightly. And the sound of the floor shifts, from the quiet buzz of desultory conversation to a mildly excited chatter. A trading floor acts as a large parabolic reflector, and through the bodies of its thousand-odd traders and salespeople it gathers information from faraway places and registers early signals from events that have yet to happen. The head of the trading floor looks up from his papers and steps out of his office, surveying the floor like a hunting dog sniffing the air. An experienced manager can sense a change in the market, tell how the floor is doing, just from the sight and sound of it.

Logan stops in mid-throw and looks over his shoulder at the screens. Scott has already wheeled his chair back to his desk. Their monitors display thousands of prices and flowing news feeds, blinking and disappearing. To outsiders the vast matrix of numbers seems chaotic, overwhelming, and finding the significant bit of information in the mess of prices and irrelevant news items seems as impossible as picking out a single star in the Milky Way. But a good trader can do just that. Call it a hunch, call it gut feeling, call it tradecraft, but this morning Scott and Logan have sensed a kaleidoscopic shift in price patterns well before they can say why.

One of the brain regions responsible for this early-warning system is the locus ceruleus (pronounced ser-u-leus), so called because its cells are cerulean, or deep blue. Situated in the brain stem, the most primitive part of the brain, sitting atop the spine, the locus ceruleus responds to novelty and promotes a state of arousal. When a correlation between events breaks down or a new pattern emerges, when something is just not right, this primitive part of the brain registers the change long before conscious awareness. By doing so it places the brain on high alert, galvanising us into a state of heightened vigilance, and lowering our sensory thresholds so that we hear the faintest sound, notice the slightest movement. Athletes experiencing this effect have said that when caught up in the flow of a game they can pick out every voice in the stadium, see every blade of grass. And today when the stable correlations between asset prices broke down the locus ceruleus tripped an alarm, causing Scott and Logan to orient to the disturbing information.

Moments after Scott and Logan have pre-consciously registered the change, they learn that one or two people on the Street have heard, or suspected, that the Fed will raise interest rates this afternoon. Such a decision announced to an unprepared financial community would send a tidal wave of volatility through the markets. As the news and its implications sink in, Wall Street, only a short while ago looking forward to calling it an early day, roils with activity. At hastily organised meetings traders consider the possible Fed moves – will it leave rates unchanged? Raise them a quarter of a percentage point? Half a per cent? What will bonds do under each scenario? What will stocks do? Having formed their views, traders then jostle to set their positions, some selling bonds in anticipation of a rate hike, which pushes the market down almost 2 per cent, others buying them at the new lower levels, convinced the market is oversold.

Markets feed on information, and the Fed announcement will be a feast. It will bring volatility to the market, and volatility to a trader means a chance to make money. So this afternoon most traders exude excitement, and many of them will make their entire week’s profit in the next few hours. Around the world bankers stay up to hear the news, and trading floors now buzz with a ludic atmosphere more commonly found at a fair or sporting event. Logan warms to the challenge and with a rebel yell dives into the seething market, selling $200 million of mortgage bonds, anticipating an exciting ride down.

By 2.10, trading on the screen dwindles. The floor goes quiet. Across the world traders have placed their bets, and now wait. Scott and Logan have readied their positions and feel intellectually prepared. But the challenge they face is more than an intellectual puzzle. It is also a physical task, and to perform it successfully they require a lot more than cognitive skills. They also need fast reactions, and stamina enough to support their efforts for the hours ahead when volatility spikes. What their bodies need, therefore, is fuel, lots of it, in the form of glucose, and they need oxygen to burn this fuel, and they need an increased flow of blood to deliver this fuel and oxygen to gas-guzzling cells throughout the body, and they need an expanded exhaust pipe, in the form of dilated bronchial tubes and throat, to vent the carbon dioxide waste once the fuel is burned.

Consequently Scott and Logan’s bodies, largely unbeknownst to them, have also prepared for the event. Their metabolism speeds up, ready to break down existing energy stores in liver, muscle and fat cells should the situation demand it. Breathing accelerates, drawing in more oxygen, and their heart rates speed up. Cells of the immune system take up position, like firefighters, at vulnerable points of their bodies, such as the skin, and stand ready to deal with injury and infection. And their nervous system, extending from the brain down into the abdomen, has begun redistributing blood throughout their bodies, constricting blood flow to the gut, giving them the butterflies, and to the reproductive organs – since this is no time for sex – and shunting it to major muscle groups in the arms and thighs as well as to the lungs, heart and brain.

As the sheer potential for profit looms in their imaginations, Scott and Logan feel an unmistakable surge of energy as steroid hormones begin to turbo-charge the big engines of their bodies. These hormones take time to kick in, but once synthesised by their respective glands and injected into the bloodstream, they begin to change almost every detail of Scott and Logan’s body and brain – their metabolism, growth rate, lean-muscle mass, mood, cognitive performance, even the memories they recall. Steroids are powerful, dangerous chemicals, and for that reason their use is tightly regulated by law, by the medical profession, by the International Olympic Committee, and by the hypothalamus, the brain’s ‘drug enforcement agency’; for if steroid production is not turned off quickly it can transform us, body and mind.

From the moment the rumour first spread, and over the past couple of hours, Scott and Logan’s testosterone levels have been steadily climbing. This steroid hormone, naturally produced by the testes, primes them for the challenge ahead, just as it does athletes preparing to compete and animals steeling for a fight. Rising levels of testosterone increase Scott and Logan’s haemoglobin, and consequently their blood’s capacity to carry oxygen; the testosterone also increases their state of confidence and, crucially, their appetite for risk. For Scott and Logan, this is a moment of transformation, what the French since the Middle Ages have called ‘the hour between dog and wolf’.

Another hormone, adrenalin, produced by the core of the adrenal glands located on top of the kidneys, surges into their blood. Adrenalin quickens physical reactions and speeds up the body’s metabolism, tapping into glucose deposits, mostly in the liver, and flushing them into the blood so that Scott and Logan have back-up fuel supplies to support them in whatever trouble their testosterone gets them into. A third hormone, the steroid cortisol, commonly known as the stress hormone, trickles out of the rim of the adrenal glands and travels to the brain, where it stimulates the release of dopamine, a chemical operating along neural circuits known as the pleasure pathways. Normally stress is a nasty experience, but not at low levels. At low levels it thrills. A non-threatening stressor or challenge, like a sporting match, a fast drive or an exciting market, releases cortisol, and in combination with dopamine, one of the most addictive drugs known to the human brain, it delivers a narcotic hit, a rush, a flow that convinces traders there is no other job in the world.

Now, at 2.14, Scott and Logan lean into their screens, gaze steady, pupils dilated; heart rates drop to a slow idle; their breathing rhythmic and deep; muscles coiled; body and brain fused for the impending action. An expectant hush descends on global markets.

THE INSIDE STORY

In this book I tell the story of Scott and Logan, of Martin and Gwen, and of a trading floor of supporting characters, as they are caught in the floodtide of a bull and then a bear market. The story will consist of two threads: a description of overt trading behaviour – how professional traders make and lose money, the euphoria and stress that accompany their changing fortunes, the calculations behind bonus payments – and a description of the physiology behind the behaviour. The threads will, however, lace together, forming a single story. Splicing the two will enable us to see how brain and body act as one during important moments in a risk-taker’s life. We will explore pre-conscious circuits of the brain and their intimate links with the body in order to understand how people can react to market events so fast that their conscious brain cannot keep up, and how they draw on signals from the body, the fabled gut feelings, to optimise their risk-taking.

Despite the traders’ frequent successes, the story follows the narrative arc of tragedy, with its grim and unstoppable logic of overconfidence and downfall, what the ancient Greeks called hubris and nemesis. For human biology obeys seasons of its own, and as traders make and lose money they are led almost irresistibly into recurrent cycles of euphoria, excessive risk-taking and crash. This dangerous pattern repeats itself in the financial markets every few years. Alan Greenspan, former chairman of the US Federal Reserve, puzzled over this periodic folly, and wrote of ‘innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation’. Much the same pattern occurs in sport, politics and war, where larger-than-life characters, believing themselves exempt from the laws of nature and morality, overreach their abilities. Extraordinary success seems inevitably to breed excess.

Why is this? Recent research in physiology and neuroscience can, I believe, help us explain this ancient, delusional and tragic behaviour. Human biology can today help us understand overconfidence and irrational exuberance, and it can contribute to a more scientific understanding of financial market instability.

A simpler reason for bringing biology into the story is that it is, quite simply, fascinating. A story of human behaviour spiked with biology can lead to particularly vivid moments of recognition. The term ‘recognition’ is commonly used to describe the point in a story when all of a sudden we understand what is going on, and by that very process understand ourselves. It was Aristotle who coined this term, and since his day recognition moments have been largely the preserve of philosophy and literature. But today they are increasingly provided, for me at any rate, by human biology. For when we understand what is going on inside our bodies, and why, we are met with repeated Aha! moments. These range from the fun: ‘Oh, so that’s why I get butterflies in my stomach when excited!’ or ‘So that’s why I get goosebumps when scared!’ (The erector pili muscles in your skin try to raise your fur, to make you look bigger, just as a cat does when threatened. Most of your fur no longer exists, so you get goosebumps instead, but where it does you have a ‘hair-raising’ experience) – to the deadly serious: ‘So that’s why stress is so tormenting, why it contributes to gastric ulcers, hypertension, even heart disease and stroke!’

Today human biology, perhaps more than any other subject, throws a light into the dark corners of our lives. So by mixing biology into the story I can more accurately describe what it feels like to take large financial risks; and I can do so moreover in a way that provides recognition moments for people who have never set foot on a trading floor. In fact, the physiology I describe is not confined to traders at all. It is the universal biology of risk-taking. As such it has been experienced by anyone who plays a sport, runs for political office, or fights in a war. But I focus on financial risk-taking, and do so for good reason: first, because finance is a world I know, having spent twelve years on Wall Street; second, and more importantly, because finance is the nerve centre of the world economy. If athletes succumb to overconfidence, they lose a match, but if traders get carried away on a flood of hormones, global markets founder. The financial system, as we have recently discovered to our dismay, balances precariously on the mental health of these risk-takers.

I begin by looking at the physiology that produces our risk-taking, filling in the background story for what follows. I then show, through a story set on a trading floor, how this physiology can mix with lax risk-management systems and a bonus system that rewards excessive gambling to produce a volatile and explosive bank. We watch as nature and nurture conspire to produce an awful train wreck, leaving behind mangled careers, damaged bodies and a devastated financial system. We then linger in the wreckage and observe the resulting fatigue and chronic stress, two medical conditions that blight the workplace. Finally we look at some tentative yet hopeful research into the physiology of toughness, in other words training regimes designed by sports scientists and stress physiologists to immunise our bodies against an overactive stress response. Such training could help calm the unstable physiology of risk-takers.

THE FEELING OF A BUBBLE

My interest in the biological side of the financial markets dates back to the 1990s. I was then working on Wall Street, trading derivatives for Goldman Sachs, then Merrill Lynch, and finally running a desk for Deutsche Bank. This was a fascinating time to trade the markets, because New York, and indeed America as a whole, was caught up in the dot.com bubble. And what a bubble that was. The markets had not seen anything quite like it since the great bull market of the 1920s. In 1991 the Nasdaq (the electronic stock exchange where many new-tech ventures are listed) traded below 600, and had meandered around that level for a few years. It then began a gradual yet persistent bull run, reaching a level of 2,000 in 1998. The Nasdaq’s rise was checked for a year or so by the Asian Financial Crisis, which reined it back about 500 points, but then the market recovered and took to the skies. In little more than a year and a half the Nasdaq shot up from 1,500 to a peak just over 5,000, for a total return in excess of 300 per cent.

The rally was almost unprecedented in its speed and magnitude. It was completely unprecedented in the paucity of hard financial data supporting the dot.com and high-tech ventures powering the bull run. In fact, so large was the gap between stock prices and the underlying fundamentals that many legendary investors, betting unsuccessfully against the trend, retired from Wall Street in disgust. Julian Robertson, for instance, founder of the hedge fund Tiger Capital, threw in the towel, saying in effect that the market may have gone crazy but he had not. Robertson and others were right that the market was due for a dreadful day of reckoning, but they also fully understood a point made by the great economist John Maynard Keynes back in the 1930s: that the markets could remain irrational longer than they, the investors, could remain solvent. So Robertson retired from the field, his reputation and capital largely intact. Then, early in 2000, the Nasdaq collapsed, giving back over 3,000 points in little more than a year, eventually bottoming out at the 1,000 level where it had begun a few short years before. Volatility of this magnitude normally makes a few people rich, but I know of no one who made money calling the top of this market’s explosive trajectory.