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Tuesday, January 13, 2009

Financial Crisis has Biological Roots Too


Successful stock traders may be physically prone to hormonal excess — a physiology that leads to success on fast-paced trading floors, but also to a global economy steered by hormonally imbalanced decision makers.

In a study of 44 London traders, the most successful tended to have longer ring fingers than index fingers, a ratio linked to high prenatal exposures to androgen, a male sex hormone. This exposure in turn is believed to increase adult testosterone levels.

By favoring ultra-aggressive hotheads, the financial world may be throwing a human-sized wrench in its own gears.

"Trading is a physical activity, requiring physical traits. Traders have to engage in visual motor scanning, and react quickly when a price discrepancy pops up," said neuroscientist John Coates of the University of Cambridge, lead author of the study and former Wall Street trading-desk operator.

"We're looking at how the market selects, and what it's selecting for. It appears that it's not selecting for rational expectations, but for biological traits," he said. If that's the case, then our vision of the market as a rational, well-oiled machine is off the mark.

A variety of traits — from sexual preference and athletic aptitude to assertiveness and aggression — have been correlated with ring-to-index finger ratio. Some of these studies have not been replicated, and have been criticized as a modern form of phrenology. But researchers do agree that the ratio tracks with prenatal androgen exposure. This early exposure is believed to determine testosterone levels during adulthood, carving a metabolic channel down which hormones can flow — and flow they do on trading room floors, where fortunes can be made and lost in minutes.

In a previous study in April of 2008, when the current financial crisis was in its infancy, Coates' team showed that trading indeed produced massive, self-reinforcing hormone fluctuation. Success drove up testosterone levels, which encouraged excessive risk-taking. Failure drove up levels of cortisol, a stress hormone that can cause excessive caution.

Coates thinks these physiological tendencies can help turn a market's normal ups-and-downs into booms and busts. The latest findings, published Monday in the Proceedings of the National Academy of Sciences, give further reason for concern.

While the April study only linked testosterone to success over the course of a few days, the new study looked at long-term effects. Judging from finger length ratios, it seems that the most successful traders are those biologically programmed for endocrine excess.

The latest study comes with caveats: Finger ratios are not a perfect surrogate for natural testosterone levels, and the findings need to be replicated outside of Coates' 44 traders. Neither, stressed Coates, does biology explain the current financial crisis. Its roots lie in misguided executive compensation schemes, wrongheaded economic policy and regulatory failure.

But leading up to the crisis — and underlying public acceptance of the mistakes and wrongdoing that produced it — was a widespread belief in the fundamental rationality of free markets and economic behaviors. That assumption may need to be revisited.

"Efficient market theory has underlain so much policy for the last 15 years. The market is supposed to select for traders or investors who display rational expectations," said Coates. "We're focusing on biology because we think the economics underlying that paradigm are built on sand."

Bruce McEwen, a Rockefeller University neuroendocrinologist, said that Coates' findings reinforce animal research on the effects of sex hormone exposure. "It predisposes the nervous system and resulting behavior to develop in certain ways," he said. "In this case, it's the development of the skills that make for success in this kind of rapid stock trading."

But Anna Dreber, a Harvard University economist, noted that though index-to-ring finger ratios are a promising measure of natural testosterone levels, they are imprecise. In their study of risk-taking in college students, Dreber and economic anthropologist Coren Apicella found no correlation between finger ratio and risky behavior.

However, Apicella said that the correlation may be strongest on a trading floor, where constant vigilance and quick reaction times are demanded.

"The emergence of behavioral economics has led to a more realistic view of human nature," Dreber said. "Understanding these causes are the next step, and this group of researchers is doing that."

Should the findings be replicated, a different approach to market structure may be required.

"There's this assumption that the market is a state of nature," Coates said. "But there are no immutable laws. They're determined by banking regulations and compensation schemes. And if you change those, you change the type of trader that is selected for."

He recommends that the high-frequency, minute-by-minute variety of trading that was the subject of this study be kept out of banking and asset management, which have lately started to move away from their traditional long-term trading practices. At a deeper level, less emphasis needs to be placed on short-term profits.

"You might find it would select for people who prefer not to be engaged in such a fast-paced style of trading, but rather one that requires complete information, wisdom and prudence," said Coates.

Citation: "Second-to-fourth digit ratio predicts success among high-frequency financial traders." By John M. Coates, Mark Gurnell, and Aldo Rustichini. Proceedings of the National Academy of Sciences, Vol. 106, No. 2, Jan. 13, 2009.

Image: Associated Press/Richard Drew