The Hour Between Dog And Wolf

The field of behavioral finance has been exploding in the past few decades. Daniel Kahneman, Robert Shiller and Richard Thaler (among others) have provided investors and the broader financial industry with a unique look at how emotions and psychology affect investment decisions. While many of the books out there today deal with the psychological aspects of investing, few dig deeper into the physiological side. The Hour Between Dog And Wolf by John Coates takes a closer examination of the feedback loop between body and mind. He explores this interaction and offers an explanation as to how it affects our ability to make decisions and take risk.

Our body senses and perceives our world both internally (interoception) and externally (sight, sound, touch, smell). When we detect a change or a threat our mind subconsciously sends signals to our body to initiate a physical reaction. These reactions start with the production of chemicals and hormones, which ready our bodies to react to what has changed in our environment. However, the response is not a one-way street. The hormones and chemicals produced by our body make their way back to our brain where they can alter the way we think.

This feedback loop is captured in “Winner Effect.” A model of testosterone-fueled animal behavior taken from the animal kingdom that may explain how investors behave during market bubbles. In a nutshell the Winner Effect says those who have won a competition come away with an advantage that helps them win future competitions. We see this occur often in sports when a given athlete or team experiences a winning streak. In some circumstances these winning streaks may simply come down to luck, but there may be a biological reason as well.

The Winner Effect model says that the anticipation of competition begins to drive an increase in testosterone production within competitors. Elevated levels of testosterone prime the human body for physical competition by helping blood carry more oxygen and improve lean muscle mass. But recall the feedback loop principle. While testosterone primes us physically it also alters the mental state of the competitors by increasing confidence and appetite for risk. Both of these effects compound as success is realized. Should a competitor win, he/she comes away with an even greater advantage: more testosterone production, more confidence and a willingness to take on even more risk. The upward spiral continues, the escalating levels of testosterone can eventually lead to excessive amounts of risk, overconfidence and result in reckless behavior–a crash!

The relationship between winning and testosterone levels has been documented in humans competing in a number of sports such as wrestling, hockey and tennis (as well as some non-athletic competitions like chess). One such study focused on tennis players who were as closely matched in rank and ability on the day of their competition. Not surprisingly the winner of the first set had a 60% chance of winning the second and thus the match. Does such a relationship exist in financial markets as well? Coates provides some evidence

I sampled testosterone from seventeen of these traders and recorded P&L over a two-week period. What we found was that their testosterone levels were significantly higher on days when they made an above-average profit. More intriguing, though, was what we found when we looked at testosterone levels in the morning, because these predicted how much money the traders would make in the afternoon. When the traders’ morning testosterone levels were high, they went on to make a lot more money in the afternoon than they did on days when their morning testosterone levels were low. [1a]

The reason that our mind and body work together in this way is to initiate a physical response and drive movement. In the past when we encountered a threat, were thrown into a new situation or sensed danger we needed to be able to move to get to safety. As we evolved the relationship between the two grew tighter as it was necessary for survival and prosperity. However, much of the stress we encounter in our modern daily lives doesn’t involve running from threatening animals on the savannah or defending our turf. Our lives have become less physically demanding over time, but the way in which our mind and body work together to respond to stress remains largely unchanged. This has tremendous consequences not just for investing, but many other areas of our lives.

There are three major instigators of a stress response: novelty (exposure to something new), uncertainty and uncontrollability. All of which are present in large amounts in the world of financial markets. When we initially encounter any of these three criteria our mind subconsciously senses a change and kick starts a fight-or-flight response. Our body begins producing adrenaline, increasing heart rate, breathing and blood pressure. Should the stress level dissipate within a short period of time then these precursors die down. However, if the stress level continues our body begins producing and additional hormone called cortisol (sometimes referred to as the “stress hormone” for this very reason).

Stress, in small amounts, followed by a period of rest can be beneficial by making us tougher and more resilient (both mentally or physically). However, chronic exposure to high levels of stress leads to excessive cortisol production. This has a poisonous effect on our bodies both physically and mentally. It shuts down many long-term functions of the body and prevents it from maintaining itself. Cortisol also causes us to become more timid and risk averse by suppressing the production of testosterone. Chronically raised blood pressure can lead to heart disease.

Much of the stress we now face has become psychological and social, and we endure this stress while sitting at a desk. The real kicker is that we have very little control over our biological response to stress. It has been programmed over thousands of years. Are we slaves to a physiological system that has yet to catch-up to modern life? Here’s some practical ways that I have dealt with these stressors over the past several years:

  1. Improve our knowledge of uncertainty: Educate ourselves with a basic history of market behavior. The stock market does not always go up, nor can we predict with any type of precision when it will rise or fall, or by how much. Over long periods of time–say several decades–the value has historically always risen.
  2. Control what we can: Don’t play the short game. Have emergency funds set aside in case the worst should happen. This prevents selling when markets are down which can lead to permanent losses. The ability to hold tight during market declines ultimately leads to superior returns in the long run.
  3. Be suspect of new things: Financial innovation seldom benefits investors. Stocks and bonds have worked just fine in the past and will continue to work well. Have a plan, keep it simple, stay disciplined, and stay on track.

1. Coates, John. The Hour Between Dog And Wolf. Penguin Group. New York, NY. 2012.
(a) p. 186

NOTES – The Hour Between Dog And Wolf.pdf

Also see The Biology of Risk by John Coates
New York Times, June 7, 2014

What I’m Reading
Most Americans can’t handle a $500 surprise bill (CBS MoneyWatch)
Resist the Powerball Temptation (Noah Smith)
Three Ways Advisors Hurt Their Clients (Sam Lee)
The Akrasia Effect: Why We Don’t Follow Through on What We Set Out to Do (James Clear)