John Coates has a few areas of expertise up his sleeve. He is currently a self-proclaimed “hardcore physiologist” and neuroscientist; but prior to that, he was trading at a Deutsche Bank desk on Wall Street. While there, his spare time was already mostly spent in the neuroscience lab at Rockefeller University.
“I was looking for an explanation for the market cycles of bubble and crisis that I saw occurring several times at the trading desk,” he says. “I realised that the work I was doing at Rockefeller could potentially explain those cycles”.
Fast forward a few years, and Coates is fully committed to the biology of risk taking – how physiological factors determine traders’ willingness to take risk, and ultimately impact financial markets. In his latest paper, posted recently onto Biorxiv, a pre-print service for biology, he shows that share prices and market crashes could all be traced back to the human immune system.
The study, The Biology of Risk-On. Decreasing Inflammatory and Stress Responses on a London Trading Floor, tracked a number of physiological reactions in 15 male traders from a mid-sized hedge fund in London during two weeks towards the end of the European Sovereign Debt Crisis. Volatility, or price moves, had therefore been high, but it was declining.
Volatility is directly linked to stress for traders – that is something that Coates had already found in previous studies. A volatile market is one in which a lot of information is shared, because prices shift more, and traders are exposed to non-stop information and surprise. High volatility was found to cause a 68 per cent elevation of cortisol, which is the main stress hormone.
This time, in addition to cortisol, Coates also measured immunological reactions by tracking the behaviour of traders’ cytokines – the cells that are responsible for signalling the presence of pathogen or infection to trigger a response from our immune system. One cell in particular, IL-1B, acts as the ‘first responder’ of the immune system. It is IL-1B which signals the release of the cortisol stress hormone, as well as the release of various other pro-inflammatory cytokines.
IL-1B was found to be directly connected to volatility: over the course of the study, the volatility index dropped by 18 per cent – and exactly the same drop was observed for IL-1B levels.
This means that, as traders were less exposed to information overload and uncertain markets, their immune system started returning to a normal state. “Volatility had just been at very high levels during the crisis,” says Coates. “As markets stabilised, we saw traders’ physiology return to baseline, from what had previously been a chronic stress condition.”
That is because the immune system reacts to information. In the face of overflowing information, and therefore greater uncertainty, our bodies react in the same way as they would in the face of an infection or pathology. And for overflowing or uncertain information, you needn’t look much further than a trading desk during the period of high volatility that is a financial crisis.
Remembering the European Sovereign Debt Crisis, a trader who worked for a large London-based hedge fund, and who wishes to remain anonymous, says: “Bloomberg at that point had launched its chat-based platform for traders. So you would be sitting with 100 chats with an average of five people. So in addition to news feeds, you would be interacting live with 500 other people. There was a heightened sense of urgency.”
Not only was there the challenge of information overload; traders also had to gauge market reactions as accurately as possible in a time of great uncertainty. “It’s the way price discovery works,” continues the trader. “You have to double guess and trade with the anticipation that the market will react in a certain way to the news.”
Except the immune system’s reaction caused by IL-1B, when it is deployed in a chronic way – as it would be during an extended period of high volatility, such as a financial crisis – affects traders’ approach to risk-taking.
IL-1B, indeed, triggers the release of cortisol, which was already shown in Coates’ previous study to induce risk-aversion. But through the release of pro-inflammatory cytokines, it can also cause sickness behaviour – a condition in which the body adapts to inflammation by conserving energy to enhance recovery. This inevitably entails aversion to behaviours that are risky.
The correlation works both ways, as Coates’ more recent research shows: when the market is stabilising, cortisol levels and IL-1B levels go back to normal, and traders become less risk-averse.
In other words, traders’ bodies follow exactly the cycles that markets go through. In a bull market, where confidence is high and volatility is low, traders are less exposed to information overload. With normal levels of cortisol and IL-1B, they are keen to take risk – sometimes too much, leading the market into a bubble that risks exploding. In a bear market, where prices fall and volatility increases, the opposite phenomenon happens. Traders will take less risk after their immune system is triggered, and the market will risk crashing.
For Robert McCusker, researcher in immunophysiology and behaviour at the University of Illinois, Coates' conclusion is a strong one. "There can definitely be a link between information overload and activity on the financial market," he says. "The release of cytokines by cells of the immune system, including an IL-1B response, affect behaviour." A change in risk assessment and risk taking, he continues, is therefore a probable outcome associated with high volatility of the financial market.
It is not the first time that market cycles have been attributed to the individual behaviour of traders. Daniel Kahneman, who won a Nobel Prize in Economic Sciences in 2002, was a pioneer of what is known as behavioural finance. He demonstrated that research in economy and finance had to include an element of psychology – as even traders cannot always act in a consistently rational way. In that light, risk-preference is not a constant; it shifts and adapts to context.
Avanidhar Subrahmanyam, researcher in behavioural science at UCLA, explains the importance of psychology in understanding the market: “Bull markets build as people’s confidence builds,” he says. “Optimism causes price rises, and because people see the future as naively representative of the past, they keep pushing them. That is what causes crashes.”
But Coates is adamant that his research sets a new approach in behavioural finance, because it is strictly physiological. Psychological factors, he explains, come in after what is a purely physical reaction from the body’s immune system to varying levels of information. “The traders we conducted research with were not even aware of the fact that they were stressed,” he says. “They were not aware of the fact that it was impacting their ability to take risk. The real phenomenon at stake here is physiological, not psychological.”
Subrahmanyam also recognises the importance of biological reactions. He describes Coates' study as "seminal," opening new perspectives on the link between financial incomes and human physiology. "This will lead to a better understanding of how to trade sensibly and design proper regulatory policy," he says.
Something to bear in mind for central banks, then. And in fact, Coates’s study ends with a recommendation for the latter. After all, to calm a bull market and avoid it morphing into a bubble, all you need is to inject a degree of uncertainty to calm traders’ willingness to take risk – and this can easily be achieved by shifting interest rates. The immune system will do the rest. It’s scientific.
This article was originally published by WIRED UK
