If you've ever wondered why financial crises develop, then you might want to start studying hormones.
According to a new paper by researchers in the United Kingdom, there's reason to believe that high levels of the stress hormone cortisol among Wall Street traders may exacerbate market crashes.
It has long been assumed that professional traders are immune to the types of emotional ups and downs that impact the average investor. When the market is up, greed causes the average investor to buy. When the market is down, fear takes over, causing many of us to sell. Rinse and repeat, and you start to get a good idea why most individual investors underperform the S&P 500 (SNPINDEX:^GSPC).
However, this latest research concludes that professional traders on Wall Street are, in fact, subject to these more pedestrian instincts.
The findings build on previous studies showing that cortisol levels among City of London traders rose by 68% during a prolonged period of heightened market volatility. With this in mind, researchers administered hydrocortisone (the pharmaceutical form of cortisol) to a sample of volunteers, artificially raising their cortisol levels by 69%. The subjects were then administered tests to measure financial risk tolerance.
By doing so, the researchers found that chronically high and sustained levels of exaggerated cortisol levels caused risk tolerance to drop. Indeed, the risk premium -- the amount of risk volunteers were willing to assume given the possibility of a higher return -- dropped by a staggering 44%.
"Any trader knows that their body is taken on a rollercoaster ride by the markets," said the study's lead author, Dr. John Coates, a former Goldman Sachs and Deutsche Bank derivatives trader and now a researcher in neuroscience and finance at Cambridge University.
"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 risks."
For anyone who invests in stocks, this is a powerful insight, as it suggests that humans, by nature, aren't programmed to be successful traders. To win in the market, in other words, it's critical to adopt a longer-term strategy of buy and hold and, importantly, to stick to it when the market is down.
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