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Mind games

Mind games

I’ve had numerous emails, WhatsApp and Telegram messages from people today wondering what’s going on in the crypto markets. Weren’t the crypto markets supposed to always be green? Why is my worth going down, not up?! And millions of people today will make bad decisions, stressed out by plummeting valuations and the stream of bearish news. They will make bad decisions because they are not predisposed to holding such a volatile asset class. In some cases this will be true. But there is more to this than a simple ‘some people make good choices because they are wired that way/more skilled’.

I recently came across an article by John M Coates which argues that risk preferences change per physiological changes within your body. Coates, a derivatives trader turned neuroscientist, argues that professional traders have “enhanced interoceptive ability compared to non-trading individuals”. In short, traders tested higher on heartbeat detection tests than their control subjects; they are able to understand what their body is telling them, and thus tap into their ‘gut instinct’, the quasi mythical catch all term that is used to explain everything from not crossing a road on a certain day to investing huge sums of money on a feeling that it is the right thing to do.

A lot of this makes sense – you would expect people whose day job it is to trade to have a good control of their emotions and body, given the stressful and intense nature of the job. But Coates also noted that a trader’s ability to tap into their gut instinct varied according to hormone levels in their body and levels of stress.

Coates and Herbert’s 2008 paper “Endogenous steroids and financial risk taking on a London trading floor” argued that city traders make above average profits on the day when they have high morning testosterone levels. They argued that testosterone increases confidence and appetite for risk. On the flip side, they also argued that rising cortisol (a hormone released in response to stress) levels heighten memory for adverse events and alters mood which decreases the likelihood of risk taking.

Coates noted that levels of testosterone rise during market bubbles whilst cortisol levels rise during market crashes. This has the effect of leading people to increase their risk appetite during the former whilst limiting it during market crashes, both of which are pronounced enough to exaggerate market movements.  Coates noted that there was a strong relationship, for example, between the level of cortisol in traders and the volatility of Bund prices.

Coates also cautioned that "Rising levels of testosterone and cortisol prepare traders for taking risk. However, if testosterone reaches physiological limits, as it might during a market bubble, it can turn risk-taking into a form of addiction, while extreme cortisol during a crash can make traders shun risk altogether." This is likely a familiar refrain to many of you who trade cryptocurrency, who find themselves constantly refreshing Blockfolio or Delta at all times of the day.

So why do I bring this up today?

I have said in the past that I force myself in a bull market to take profits when I want to hold on for more and to hold or buy in a market dip when all I want to do is sell. I have always felt that during sustained market dips (i.e. longer than a few days) I am going against what my body is urging me to do, despite trusting my gut instinct explicitly the vast majority of the time. The research presented by Coates and the associated researchers goes some way to explaining why that is so.

The other reason is that the cryptocurrency market is like a normal market on steroids. Everything moves faster and more violently. A week in crypto feels like months, with prices capable of not just doubling or tripling, but nonupling and decupling (that’s 9 or 10x to save you looking it up as I had to) within a seven day span. The reverse is also true, with prices falling 60-70% with ease. As such, it may stand to reason that the effects described by Coates are even more pronounced, particularly as the majority of money in the market likely remains that of retail investors who are less likely to have enhanced interoceptive abilities. Dips may become harder as people fall hostage to emotions; bubbles may last longer as they steadfastly take on more and more risk. 

Cryptocurrencies are in many ways the ultimate casino. Open 24 hours a day, thousands of coins and trading pairs to suit your fancy. If you get bored of one – there’s always another. Maybe you’ll get lucky on that one. In years to come, should the market continue to expand, I would not be surprised to see an inverse relationship to bookmaker’s profits, such is their appeal. However, it is this intense and relentless nature of the crypto market which means it is of the utmost importance to recognise the strengths and the failings of your own body.

I do not claim to know how the market will perform in the next two days, let alone 2018 (although I suspect we'll start to see an uptick soon). Maybe it crashes, maybe it doesn’t. However, by understanding some of the factors that makes us act the way we do, it is possible to be better prepared to deal with market extremes. 

Sources included:

Coates, J.M and Herbert, J, Endogenous steroids and financial risk taking on a London trading floor, MoneyScience  (2008).

Kandasamy, N. et al. Interoceptive Ability Predicts Survival on a London Trading Floor. Sci. Rep. 6, 32986; doi: 10.1038/srep32986 (2016)

Ethorse: Yay or Neigh?

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Part 2: Is the market in a bubble?

Part 2: Is the market in a bubble?