A review of “The hour between dog and wolf” by John Coates
John Coates presents an engaging story of recent financial crashes from the perspective of a group of traders. Within this, he weaves an entertaining account of their biology and how this changes the risks they take. Testosterone and cortisol are the two steroidal stars of the story. Coates links elevated levels of these hormones to the economic boom and bust cycles. But how can trader's improve, can they learn from athletes?
Coates is a former trader with Goldman Sachs, Merrill Lynch and Deutsche Bank. He also gained a PhD in Economics from Cambridge. When the markets were slack in New York, he attended lectures at Rockefeller University on his new passion, psychology and neuroscience. It was here that he first heard of the Winner Effect.
This Winner effect was first observed in male animals battling for pack dominance. When a pair fight, their fight and flight response kicks off a process that leads to an increase in testosterone. This steroid has a physiological effect increasing oxygen carrying capacity and muscle mass. It also has a neurological effect increasing the winners confidence and appetite for risk. Having won a fight, the winner’s testosterone levels increase even further. The winner, having an edge in all these areas, thus increases the likelihood of them winning again.
This effect has been observed in sportsman leading to winning streaks. However, as steroid levels spiral upwards, animals take bigger risks. They spend more time in the open and start more fights. This impetuosity increases the risk of losing at some point. In humans, this increase results in over-confidence and increasingly reckless behaviour. For the loser the opposite occurs. Over long periods, the constant stress of potential failure leads to over production of another steroid, cortisol. This has been observed to degrade confidence and lead to an increased unwillingness to take even sensible risks. Cortisol exposure over the long term also has serious negative health consequences.
Coates links the combined effects for winners and losers to the spiraling and collapsing of markets during bubbles. Greenspan coined the term irrational exuberance to describe the Dotcom boom. Following the crash, commentators adopted the opposite term, irrational pessimism, to describe traders chronic lack of willingness to take risks. This difference was a stark contrast to the risks traders took when the markets were rising and testosterone levels were high.
Coates’ research examines the Winner Effect in traders. He tested their testosterone levels and measured their skill. His research found that traders with greater testosterone in their blood in the mornings did make more money. However, they made more money by taking bigger risks. This was calculated using the Sharpe Ratio. This measures how much risk is taken to make a given amount of money. An example of a low Sharpe Ratio is making a total profit in a year of £100 million but making or losing £500 million in a single day. Coates states this is more likely to be down to luck. A high ratio would be a profit of £100 million in a year but making or losing only £5 million in a day. Coates study found examples of traders who had high Sharpe Ratios. For some, these ratios were consistent and also increased over time, suggesting their skill was improving.
This idea goes against the Efficient Market Hypothesis. This idea purports that markets move in reaction to new information. As new information cannot be predicted, so neither therefore can markets be predicted. I have a criticism of Coates views of skill in trading. His book does not make it clear how many traders were in this skilled category. Were the numbers of adept traders statistically significant? Equally, even if a trader is profitable taking low risks, does this mean they have increased skill or are they lucky in a different way?
Coates proposes measures to counteract the boom and bust cycle aiming to reduce testosterone on the trading floor. Some are not new: eg. banks should reward over long periods not the yearly bonus round. Some are newer: more women and older men should be employed who are less vulnerable to testosterone. His most complex idea proposes hiring traders who are more physiologically and psychologically resilient. Specifically those that are better able to harness their vagus nerve. This is part of the nervous system that appears to engage a brake in stressful situations before a decision is made. It provides a period of reflection allowing the learned long-term brain circuits to engage instead of the less skilled short term fight and flight circuits. Coates also suggests methods by which the vagus nerve can be trained.
Perhaps Coates could have suggested treating traders more like modern sports teams. This idea is dependent on trading being a skill that can be developed. This may be controversial as I mentioned above. Today’s top athletes have their blood tested, heart rates monitored, movement monitored and diets controlled. They are constantly trained and increasingly psychologists are used to increase performance. So why not try this with traders?