Swedroe: How To Protect Us From Ourselves

July 02, 2014

A superb book on behavioral finance could truly help investors everywhere.

I recently read “The Hour Between Dog and Wolf” by John Coates, and it’s one of the best books on human behavior and finance I’ve ever come across. It could literally help investors get protection from their greatest enemies: themselves.

By way of background, Coates is a senior research fellow in neuroscience and finance at the University of Cambridge. After completing his doctoral degree, he worked for Goldman Sachs, Merrill Lynch and Deutsche Bank in New York, where he observed the powerful emotions driving traders.

Coates returned to Cambridge in 2004 to research the effects of the endocrine system on financial risk-taking. His book, published in 2012, is a great complement to Jason Zweig’s “Your Money and Your Brain.”

Coates’ work is a tour de force revealing how risk-taking transforms our body chemistry, driving us to extremes of euphoria and more risky behavior as well as stress and depression. It’s a must-read for those interested in the field of behavioral finance, and a valuable read for all investors.

The title is taken from a French saying, “L'heure entre chien et loup,” which refers to the moments after sunset when the sky darkens and vision becomes unclear, making it difficult to distinguish between dogs and wolves, or friends and foe.

Coates explains how “hot” or “cold” streaks “can change us, Jekyll-and-Hyde-like, beyond all recognition. On a winning streak, we can become euphoric, and our appetite for risk expands so much that we turn manic, foolhardy and puffed up with self importance.

On losing, we struggle with fear, reliving the bad moments over and over, so that stress hormones linger in our brains, promoting a pathological risk aversion, even depression. Those hormones circulate in our blood, contributing to recurrent viral infections, high blood pressure, abdominal fat buildup and gastric ulcers.

Financial risk-taking is as much a biological activity, with as many medical consequences, as facing down a grizzly bear. You might recall how you were feeling during the dot-com bubble and the ensuing bear market, or during the financial crisis of 2008.

Having run trading rooms for two leading financial institutions, and been an advisor to institutional and individual investors for 20 years, I can attest that Coates’ insights ring all too true.

For example, he notes that “greed certainly can and does cause investors to run with the profits too long … A bull market starts to validate investors’ beliefs, the profits they make translate into a lot more than greed: They bring on powerful feelings of euphoria and omnipotence. It is at this point that traders and investors feel the bonds of terrestrial life slip from their shoulders and they begin to flex their muscles like a newborn superhero. Assessment of risk is replaced by judgments of certainty—they just know what is going to happen: Extreme sports seem like child’s play, sex becomes a competitive activity. They even walk more erect, more purposeful, their very bearing carrying a hint of danger: ‘Don’t mess with me,’ their bodies seem to say. ‘I can handle anything.’ They become ‘masters of the universe.’”

Coates explains that “the overconfidence and hubris traders experience during a bubble or a winning streak … feels as if it is driven by a chemical, as opposed to rational assessment of opportunities. When traders enjoy an extended winning streak they experience a high that is powerfully narcotic.”

 

 

Find your next ETF

Reset All