/The real culprit behind irrational financial decisions

The real culprit behind irrational financial decisions

By Dr. Neelam Rani and Rohit Garg

In his book “Thinking, Fast and Slow,” Daniel Kahneman, Nobel Prize-winning economist, has written, “you think with your body, not only with your brain.”

Decisions taken by humans are affected by the biases and emotions that may distort our best rational judgment. All of our decisions are widely varied by factors like sleep, hunger, emotions, and other physiological factors. The decisions affected can be very general, like whether to talk to someone; or very complicated like a financial decision. The relationship between the financial system and emotions becomes more complex with time as the financial system evolves, but emotions don’t.

Human brains are not rational computers; emotions play a vital role in this, and what controls human emotions is the hormones. Hormones guide the choices of humans and even their risk perception. Testosterone, the male hormone (found in females in minimal amount), is associated with aggressive behavior, confidence, competition, and optimism, whereas cortisol is connected with fear, risk-averse behavior.

If a person has a high level of testosterone, such as in a stressful or a competitive environment, then they will have higher confidence, and they will be more optimistic. For example, a person with a high testosterone level will place a high amount of trades at a high price, even in riskier assets. High-frequency trading, which involves significant amounts of money, is done by people who are confident about their trades and have a good understanding of the market. The person should be in a proper state of mind while placing the trades. Otherwise, they may end up making risky decisions.

When traders are on a winning spree, the level of testosterone surges, sparking such feeling that they underestimate risk. This may hurt the balance of the market, leading to high volatility in prices and more uncertainty. For an average trader, the fundamental is to buy at a lower price and sell at a higher price. However, a person with a higher level of testosterone will buy at a high price and will sell at an even higher price because of his increased optimism, confidence, and risk-seeking attitude.

Whereas on the other hand, cortisol is the reason why people refrain from buying undervalued shares, having the potential to earn a substantial profit. The higher level of cortisol can also be the reason for the failure of traders because they need to take an adequate amount of risk to earn money, and this hormone discourages them from doing so. All of this can lead to price bubbles or erratic behavior in financial markets such as the 2008 financial crisis, which was due to a large number of issued credit securities, and default by one participant that had a ripple effect.

The recent pandemic, Covid-19, has also haunted the world. World stock markets are again beaten down. This also opens up many opportunities to buy quality stocks at low prices. However, people with high levels of cortisol will be risk-averse, and they will resort to safe-haven assets like gold, US dollar, Swiss franc, Japanese yen and so on.

Due to the massive buying spree, the prices of these assets increase, and that of others decreases because people pull out their money from other asset classes to invest in these. Since this is a known phenomenon, people who are late in predicting the crisis will be unable to catch the higher return. However, testosterone will force people to invest in these assets at even higher prices.

The role of hormones is evident not only in the financial markets but also in other areas of the finance industry. In mergers and acquisitions too, investment bankers are involved for both the buy-side and the sell-side. It is the natural tendency of the buyer to quote a lower price while the seller tends to quote a higher price. So if the people involved in valuation have a high level of testosterone, they will be overconfident and more optimistic about the prospect without discounting the risk appropriately, and this will result in a higher valuation of the business. The acquiring company will end up paying a higher price for the acquisition. It has been found in many research that young entrepreneurs or CEOs are more combative in case of hostile acquisitions by other companies, and they are more likely to force the bidder to resort to the tender offer. This combative nature is the result of higher testosterone generated in their bodies. And the opposite happens when these entrepreneurs or CEOs attempt an acquisition. These acts of attempting or resisting a purchase can be attributed to achieving dominance.

However, the challenge remains- how to minimise the impact of hormones on risk-taking, optimism, and other financial decisions. But as it is said, the solution of the problem lies in the problem itself; the hormones and emotions themselves can contribute to the solution. Maybe we can have devices or some mechanism to track and analyse hormone levels to detect dominant hormones at the decision-making point of time. If hormonal status falls in the wrong decision-making category, then getting instant notifications to stop or reconsider that decision. Maybe.

(Dr Neelam Rani, Associate Prof (Finance) and Rohit Garg (Post Graduate Program, 2018-20), Indian Institute of Management, Shillong.)

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