Market Crash Stressing You Out? It Should…

Market Crash Stressing You Out? It Should…

April 21, 2014 Behavioral Finance
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(Last Updated On: January 18, 2017)

Cortisol Shifts Financial Risk Preferences

Abstract:

Risk taking is central to human activity. Consequently, it lies at the focal point of behavioral sciences such as neuroscience, economics, and finance. Many influential models from these sciences assume that financial risk preferences form a stable trait. Is this assumption justified and, if not, what causes the appetite for risk to fluctuate? We have previously found that traders experience a sustained increase in the stress hormone cortisol when the amount of uncertainty, in the form of market volatility, increases. Here we ask whether these elevated cortisol levels shift risk preferences. Using a double-blind, placebo-controlled, cross-over protocol we raised cortisol levels in volunteers over 8 d to the same extent previously observed in traders. We then tested for the utility and probability weighting functions underlying their risk taking and found that participants became more risk-averse. We also observed that the weighting of probabilities became more distorted among men relative to women. These results suggest that risk preferences are highly dynamic. Specifically, the stress response calibrates risk taking to our circumstances, reducing it in times of prolonged uncertainty, such as a financial crisis. Physiology-induced shifts in risk preferences may thus be an unappreciated cause of market instability.

Alpha Highlight:

As the market hits turmoil, cortisol kicks in. As cortisol kicks in, risk-aversion goes up…

PNAS-2014-Kandasamy-1317908111 (1)

Physiology affects behavior–be careful!

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About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes, ETF.com, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.