Trading is mostly about neurochemistry. That is the persuasive argument of former trader and current neuroscientist John Coates in his book “The Hour Between Dog and Wolf”. The implication is clear: men have too many of the wrong hormones to be trusted.
Coates believes traders have similar neurochemistry to elite athletes. Like these sportsmen, true short-term traders do not make great use of cognitive abilities, because those reactions are too slow; instead their responses are guided by subconscious fast reactions. In less scientific terminology, they follow carefully honed instincts rather than methodical reasoning.
Instincts, though, are influenced by hormones. In particular, successful traders have higher levels of testosterone than their unsuccessful peers. Coates found that both risks and returns were higher for traders with high testosterone levels.
High testosterone enhances trader reactions in short periods of moderate levels of stress – normal market conditions. That is the contemporary equivalent of prehistoric hunting and a less hazardous substitute for combat. However, high testosterone is not helpful when the level of stress is also high or when prolonged stress is accompanied by negative outcomes. In these cases, traders with high testosterone levels tend to take excessively irrational risks. In extreme cases the cortisol hormone takes over, overwhelming all rational responses and producing an irrational fear of market activity.
Coates distinguishes between true short-term trading and activities such as fund management and execution of sales-driven orders, in which testosterone plays a lesser role and women (who generally, although not universally, have much lower testosterone levels) can be highly effective. He also makes it clear that trader remuneration systems, which involve exceptional rewards for successful trading, play a major role in producing the neurological reactions seen.
Coates alternates between biological explanation and trading room illustration. He goes in detail through various trader reactions, showing how biology plays a major role. In the final chapter, he steps back and examines the implications of trader neurochemistry and bank risk/reward systems, and agrees with many market critics who suggest that the current biological/incentive combination is not conducive to a stable financial system. The feedback loop in most trading institutions which rewards trader success with larger position limits is especially dangerous.
Although Coates does not draw any lessons for regulators, the implications of his analysis are clear. If the economic purpose of traders is to provide markets with liquidity, then there should be more bad (albeit active) traders. They are just as economically useful as their more talented peers, but extract far fewer “rents” in the form of their own remuneration.
It may be hard to persuade banks to hire bad traders for the sake of the common good. But it is quite realistic to require banks, especially those deemed “too-big-to-fail”, to remunerate traders in such a way as to minimize the additional personal payoff from success. Coates’ analysis suggests that an alternative would be only to employ women, a policy which might just pass sex-discrimination muster as relying on the unavoidable biological differences between the sexes. Either way, the high-testosterone types should be left to the hedge funds, which injure only their foolish shareholders and lenders when they fail.
Coates’ book is both convincing and disturbing; it is essential reading for bank top management and the regulatory community.