How human biology can explain the behavior that drives banks to the brink of disaster

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As the world's economy struggles to pull out of a recession, traders work on the floor of the New York Stock Exchange in the New York financial district on Wall Street on April 8, 2009 in New York City.

Coates' latest book is The Hour Between Dog and Wolf: Risk Taking, Gut Feelings and the Biology of Boom and Bust

Every so often we read of a star trader who has lost so much money that he has given back all the profits he made in the previous few years and shaken his bank to its foundations. How on earth does this happen? Were the risk managers at the bank mistaken all along about this traders skill?

Maybe. But recent research in physiology and neuroscience suggests an alternative explanation that the winning streak itself changed the trader. Human biology can today help explain the behavior that drives traders to acts of folly.At the heart of this research lies an important fact that is frequently overlooked: when we take risk, including financial risk, we do a lot more than think about it we prepare for it physically. Body and brain fuse as a single functioning unit.

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Consider what happens when an important piece of news flashes across the wire. At that very instant, across the trading floor, traders senses are placed on high alert, allowing them to hear the faintest noise, see the slightest movement. Breathing accelerates, and they feel the thump of a heart gearing up for action. Muscles tense, stomachs knot and an imperceptible sheen of sweat creeps across their skin, anticipatory cooling for the expected activity. We do not regard information as a computer does, dispassionately. We register it physically.

This fusion of body and brain normally endows us with the fast reactions and gut feelings we need to survive in a brutal world, and a brutal market. My colleagues at the University of Cambridge and Ihave conducted a series of experiments on a trading floor in London and found thatunder circumstances of extraordinary opportunity otherwise known as a winning streak our biology can overreact, and our risk taking become pathological. A model from animal behavior, called the winner effect, provides an intriguingly illustration of how this can happen. When males enter a fight or competition their testosterone surges which increases their hemoglobin and hence their bloods capacity to carry oxygen; and in the brain it increases confidence and appetite for risk. The winner emerges with even higher levels of testosterone and this heightens his chances of winning yet again, leading to a positive feedback loop. For athletes preparing to compete, traders buying risky assets, even politicians gearing up for an election, this is a moment of transformation,what the French in the Middle Ages called the hour between dog and wolf.

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The rest is here:
The Anatomy of a Huge Trading Loss