Financial Risk: Perspectives from psychology and biology

During the last week, I found myself reading two different perspectives on financial risk:

1. A fascinating paper by Anat Bracha and Elke Weber entitled “A Psychological Perspective of Financial Panic” (h/t Mostly Economics).
2. A marvellous book by John Coates called The Hour Between Dog and Wolf: Risk Taking, Gut Feelings and the Biology of Boom and Bust.

The main thesis of Bracha and Weber is that:

... perceived control is a key concept in understanding mania and panic, as the need for control is a basic human need that contributes to optimism bias and affects risk perception more generally. Lack of control is therefore a violation of a basic need and will trigger episodes of panic and retreat to the safe and known.

The illusion of control refers to the human tendency to believe we can control or at least influence outcomes, even when these outcomes are the results of chance events.

The book by Coates is much more complex. The title itself requires a whole paragraph of explanation – it translates a French phrase that refers to the time around dusk when it is difficult to determine whether a shadow that one is seeing is that of a dog or a wolf, implying that the one could metamorphose into the other at any time.

From a biological perspective, it appears that:

... researchers have found that three types of situations signal threat and elicit a massive physiological stress response – those characterized by novelty, uncertainty and uncontrollability

...

Novelty, uncertainty and uncontrollability – the three conditions are similar in that when subjected to them we have no downtime, but are in a constant state of preparedness.

The uncontrollability that the psychologists emphasize is present in the biologist's description as well, but it does not seem to have a privileged position compared to other forms of risk – novelty and uncertainty. The biological response to all these forms of risk is the same – the body is flooded with stress hormones (mainly cortisol) which command the body to “shut down long term functions of the body and marshal all available resources, mainly glucose, for immediate use.”

More interesting is that the biological (unconscious) stress response closely mirrors the objective reality unlike the self reported (conscious) risk perception that is elicited by questionnaires. In his research with a groups of bond market traders, Coates asked the traders to report their level of stress at the end of each day. This self reported stress was totally unrelated either to their losing money or swings in their P&L or the volatility in the market. At the same time, their cortisol level faithfully measured the volatility that the individual traders were experiencing. That is not all – the average cortisol level of this group of traders very closely tracked the implied volatility of options related to the bonds that they were trading.

Coates links this finding to what biologists had found with rats. After several days of being placed in an objectively dangerous situation, the rats got habituated to the situation and became outwardly calm. However, their stress hormones reflected the stress that existed. Again, the unconscious biology reflected the objective reality while the conscious behaviour did not.

This seems to suggest that the “illusion of control” that Bracha and Weber talk about may be an illusion that afflicts only the conscious mind and not the unconscious mind that governs actual risk taking. Biology teaches us to assume that millions of years of evolution have perfected the more primitive (unconscious) parts of the brain to achieve near optimal behaviour (at least relative to the original environment). The more recent (conscious) parts of the brain perhaps have still some way to go before reaching evolutionary perfection.

Posted at 10:58 am IST on Sun, 3 Feb 2013         permanent link

Categories: behavioural finance, interesting books

Comments