Best practice | The human factor
“When you take a risk, you face a threat, a potential hurt. And when humans are under threat, the body responds by preparing for action.” John Coates
before will win again, so it is that the testosterone- fuelled trader who has placed a winning bet before will do so again. This is the physiology behind the familiar image of the trader on a winning streak. At some point in this upward victory spiral,
however, testosterone overshoots and judgement becomes impaired. As a result, effective risk-taking morphs into overconfidence. Prudence gives way to recklessness. The star trader places ever- increasing bets despite ever-worsening risk-reward tradeoffs. Then one day, just like the London Whale, his positions blow up.
At this point, another hormone, cortisol, sends the trader at the losing end of the game on a downward spiralling trajectory. As the body’s stress response goes into overdrive, anxiety rises, danger is perceived where there is none and an irrational risk aversion takes over. The end result is another widely observed phenomenon on trading floors: the trader whose confidence is shot, whose ability to trade, even in clement market conditions, is paralysed.
The human factor In the hard-bitten financial world, a physiological explanation of traders’ winning and losing streaks, and the irrational exuberance and pessimism they engender, may seem outlandish but, judging by the interest in Coates’ ideas, there is some acceptance
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that the theory does chime with practice. “The idea that risk-taking has a biological dimension, that the state of your body might be predicting your performance in markets, may seem odd at first. But traders quickly recognise a truth in what I’m saying. They see it explains why they so often succumb to recklessness at the end of a winning streak and why, when losses mount, they experience extreme stress and fatigue,” says Coates. The notion that trading has a powerful human dimension clearly has major and wide- ranging implications for banks, starting with risk management, where the introduction of a warmer human touch could help risk managers curb individual traders’ wilder excesses. “In my view, managing risk is a human activity,”
says Marcus Cree, vice president, risk solutions at SunGard. “But right now too much time is spent in back-offices producing numbers and reports. Risk managers need to get out on the floor and engage with the mentalities and personalities of traders. An effective risk manager is the person a head trader can consult in volatile markets and say, ‘OK, things are going crazy here. Who are the people we need to watch?’”
One way risk managers could answer this key question, says Cree, is to collect information on how individual traders react under calm and stressful market conditions. These profiles could then be built into stress testing and risk budgeting, with each individual trader being set an individual risk limit according to their personal trading style. Re-establishing human connections on the trading floor could also mitigate reckless risk-taking through improved monitoring, according to Paul Hayward, acting managing director of OANDA, EMEA. “When I was trading up until the mid- nineties, before technology took hold, there was a lot of human interaction. You were constantly speaking to other departments, explaining decisions to your bosses or colleagues and people could see what others were doing. It was almost self-policing.” Reverting to some kind of apprenticeship where junior traders are guided through the idiosyncrasies of different market cycles under the wing of seasoned traders until judged fit to fly solo, may
Best Execution | Spring 2013
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