CONFRONTING RISK

When you take risks, you are reminded in the most insistent manner that you have a body. For risk by its very nature threatens to hurt you. A driver speeding along with a winding road, a surfer riding a monster wave as it crests over a coral reef, a mountain climber continuing his ascent despite an approaching blizzard, a soldier sprinting across no-man’s land — each of these people faces a high chance of injury, even death. And that very possibility sharpens the mind and calls forth an overwhelming biological reaction known as the ‘fight-or-flight’ response. In fact, so sensitive is your body to the taking of risk that you can be caught up in this visceral turmoil when death poses no immediate threat. Anyone who plays a sport or watches from the stands knows that even when it is ‘just a game’, risk engages our entire being. Winston Churchill, a hardened campaigner from the most deadly wars, recognized this power of non-lethal risk to grip us, body and mind. When writing of his early years, he tells of a regimental polo match played in southern India that went to a tie-break in the final chukka: ‘Rarely have I seen such strained faces on both sides’, he recalls. ‘You would not have thought it was a game at all, but a matter of life and death. Far graver crises cause less keen emotion’.

Similar strong emotions and biological reactions can be triggered by another form of non-lethal risk — financial risk-taking. With the exception of the occasional broker suicide (and these may be more myth than reality), professional traders, asset managers and individuals investing from home rarely face death in their dealings. But the bets they place can threaten their job, house, marriage, reputation and social class. In this way money holds a special significance in our lives. It acts as a powerful token distilling many of the threats and opportunities we have faced over cons of evolutionary time, so making and losing it can activate an ancient and powerful physiological response.

In one important respect, financial risk carries even graver consequences than brief physical risk. A change in income or social rank tends to linger, so when we take risks in the financial markets we carry with us for months, even years after our bets have settled, an inner biological storm. We are not built to handle such long-term disturbances to our biochemistry. Our defence reaction were designed to switch on in an emergency and then switch off after a matter of minutes or hours, a few days at the most. But an above-average win or loss in the markets, or an ongoing series of wins or losses, can change us, Jekyll-and-Hyde-like, beyond all recognition. On a winning streak we can become euphoric, and our appetite for risk expands so much that we turn manic, foolhardy and puffed up with self-importance. On a losing streak we struggle with fear, reliving the bad moments over and over, so that stress hormones linger in our brains, promoting a pathological risk-aversion, even depression, and circulate in our blood, contributing to recurrent viral infections, high blood pressure, abdominal fat build-up and gastric ulcers. Financial risk-taking is as much a biological activity, with as many medical consequences, as facing down a grizzly bear.

This statement about biology and the financial markets may sound strange to ears accustomed to the teachings of economics. Economists tend to view the assessment of financial risk as a purely intellectual affair — requiring the calculation of asset returns, probabilities, and the optimal allocation of capital — carried on for the most part rationally. But to this bloodless account of decision-making I want to add some guts. For recent advances in neuroscience and physiology. Our bodies, expecting action, switch on an emergency network of physiological circuitry, and the resulting surge in electrical and chemical activity feeds back on the brain, affecting the way it thinks. In this way body and brain twine as a single entity, united in the face of challenge. Normally this fusion of body and brain provides us with the fast reactions and gut feelings we need for successful risk-taking. But under some circumstances the chemical surges can overwhelm us; and when this happens to traders and investors they come to suffer an irrational exuberance or pessimism that can destabilize the financial markets and wreak havoc on the wider economy.

To give you a mere inkling of how this physiology works, I am going to take you onto the trading floor of a Wall Street investment bank. Here we will observe a high-stakes world where young bankers can step up or down a full social class in the space of a single bonus season, one year buying a beach house in the Hamptons, the next pulling their kids out of private school. So consider if you will the following scenario, in which an unanticipated and important piece of news impacts an unsuspecting trading floor.

August 2012