Swedroe: How To Protect Us From Ourselves

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

Reviewed by: Larry Swedroe
Edited by: Larry Swedroe

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.”


He also notes that it “is very difficult to control … Every trader knows the feeling … Under its influence we tend to feel invincible, put on stupid trades in such large size that we end up losing more money on them than we made on the winning streak that kindled this feeling of omnipotence in the first place.”

They are literally transformed into different people. This behavior creates the environment that can lead to financial crashes like the one we experienced in 2008.

Coates relates the story of Randolph Nesse, a psychiatrist at the University of Michigan, who in 2000 hypothesized that “the dot.com bubble differed from previous ones because the brains of many traders and investors had changed—they were under the influence of now widely prescribed antidepressant drugs such as Prozac. Human nature has always given rise to booms and bubbles followed by crashes and depressions … But if investor caution is being inhibited by psychotropic drugs, bubbles could grow larger than usual … with potentially catastrophic economic and political consequences.” Given the events that followed just eight years later, Nesse seems prescient.

Coates’s research on steroid hormones we produce led him to the following hypothesis: “Testosterone … is likely to rise in a bull market, increase risk taking and exaggerate the rally, morphing into a bubble. Cortisol, on the other hand, is likely to rise in a bear market, make traders dramatically and perhaps irrationally risk averse and exaggerate the sell-off, morphing into a crash. Steroid hormones building up in the bodies of traders and investors may thus shift risk preferences systematically across the business cycle, destabilizing it.”

Demonstrating this point, Coates found that “shell-shocked traders, under the influence of an overly active amygdala (a small, almond shaped mass of nuclei located in the temporal lobes of the brain near the hippocampus that functions to control fear responses, the secretion of hormones, arousal and the formation of emotional memories), become prey to rumor and imaginary patters.”

He cited a study by two psychologists who presented meaningless and random patterns to healthy participants, who appropriately found nothing of significance in them. They then exposed people to an uncontrollable stressor. Those under stress did find patterns in what was nothing more than noise.

Coates’ findings on how we react to stress have implications not only for traders and investors, but for corporations as well. The research shows that feelings of uncertainty and uncontrollability create stress in the workplace, as well as outside it, and that stress leads to physical damage, increasing sickness and even death rates, and, of course, higher medical expenses.

The fact that our bodies can “betray” us in ways in which we are unconscious is important knowledge. Having a well-developed, written and—importantly—signed investment-policy statement that requires rebalancing whenever an asset exceeds a pre-established minimum or maximum allocation can provide needed discipline.

Such discipline can help investors overcome the feelings of greed in bull markets (when testosterone levels rise) and the feelings of panic in bear markets (when cortisol levels rise). And if you find that even this precaution isn’t sufficient, additional oversight is one of the many ways a good financial advisor can add value, in effect providing the discipline that your body’s chemistry is preventing you from maintaining on your own.

Larry Swedroe is the director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

Larry Swedroe is a principal and the director of research for Buckingham Strategic Wealth, an independent member of the BAM Alliance. Previously, he was vice chairman of Prudential Home Mortgage.