I thought this was a fun read. Some excerpts below.

"The Biology of Risk" :

In one of my studies, conducted with 17 traders on a trading floor in London, we found that their cortisol levels rose 68 percent over an eight-day period as volatility increased. Subsequent, as yet unpublished, studies suggest to us that this cortisol response to volatility is common in the financial community.

A question then arose: Does this cortisol response affect a person's risk taking? In a follow-up study, my colleagues from the department of medicine pharmacologically raised the cortisol levels of a group of 36 volunteers by a similar 69 percent over eight days. We gauged their risk appetite by means of a computerized gambling task. The results, published recently in the Proceedings of the National Academy of Sciences, showed that the volunteers' appetite for risk fell 44 percent.

Most models in economics and finance assume that risk preferences are a stable trait, much like your height. But this assumption, as our studies suggest, is misleading. Humans are designed with shifting risk preferences. They are an integral part of our response to stress, or challenge. When opportunities abound, a potent cocktail of dopamine — a neurotransmitter operating along the pleasure pathways of the brain — and testosterone encourages us to expand our risk taking, a physical transformation I refer to as "the hour between dog and wolf."

One such opportunity is a brief spike in market volatility, for this presents a chance to make money. But if volatility rises for a long period, the prolonged uncertainty leads us to subconsciously conclude that we no longer understand what is happening and then cortisol scales back our risk taking.

In this way our risk taking calibrates to the amount of uncertainty and threat in the environment. Under conditions of extreme volatility, such as a crisis, traders, investors and indeed whole companies can freeze up in risk aversion, and this helps push a bear market into a crash.

Unfortunately, this risk aversion occurs at just the wrong time, for these crises are precisely when markets offer the most attractive opportunities, and when the economy most needs people to take risks. The real challenge for Wall Street, I now believe, is not so much fear and greed as it is these silent and large shifts in risk appetite.

I consult regularly with risk managers who must grapple with unstable risk taking throughout their organizations. Most of them are not aware that the source of the problem lurks deep in our bodies. Their attempts to manage risk are therefore comparable to firefighters' spraying water at the tips of flames.

Stefan Jovanovich writes:

One of the luxuries of sitting in the bleachers here in Spec Park is that you have all this time between innings to ask yourself questions about what the players are doing on the field.

Gary's referral to the latest wisdom from the New York Times raises a new query: Isn't "risk" simple the word that is used in financial theology instead of "sin"? Everyone is against it, but no one can define it until after someone has lost a large amount of money.

P.S. The suggestion that "firefighters' spraying water at the tips of flames" is foolish is dead wrong. That is precisely where the water is supposed to go so it can disperse the gases that are the actual fire. One of the first things shipboard firefighters learn is precisely any water sprayed anywhere else is not only stupid but dangerous. When the Forrestal had its fire, the greatest danger to the ship came from too much water being used; it almost sank the ship.





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