The hormones that influence our risk taking and decision making
Research has shown that physiological and psychological stress both influence our hormones and, as a result, affect our behaviour. Most importantly in a business context, our risk-taking behaviour is affected in ways which might not be evident to us. We tend to consider risk-taking as an intellectual activity but in reality it is a profoundly physical experience. Often enough we have however to take decisions during stressful situations so knowing about these possible biological factors can help us improve our decision making and more than anything, the risk taken
Cortisol and testosterone are two of the hormones influenced by stress. Cortisol raises as a response to stress. It relates to our fight or flee instinctive response to unexpected danger. As a result, there is documented evidence that acute stress makes us prone to taking instinctive habitual decisions. This type of decisions is part of our everyday life and often necessary as we do not have to rationalise the response to situations on which we can easily decide based on pour experience and past learnings. Having the ability to decide fast is desirable if our intuitive response is correct and we are more likely to act well in a familiar environment. However, in high stress situations this reflex response might not be the best one as circumstances can require us to reconsider our goals and the means for achieving those goals. Moreover, studies have shown that when our cortisol level is high we are more likely to rely on our gut responses and fall victim to apparently “silly” mistakes. The commonly used questions are one or more of the following cognitive reflection tests developed by Dr. Frederick:
1.A bat and a ball cost $1.10 in total. The bat costs $1.00 more than the ball. How much does the ball cost?
2. If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets?
3. In a lake, there is a patch of lily pads. Every day, the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long would it take for the patch to cover half of the lake?
The intuitive answers to these questions typically are: 10 cents, 100 minutes, and 24 days; while the correct solutions are: 5 cents, 5 minutes, and 47 days.
As a result of changes in cortisol levels, several studies have shown that our risk-taking behaviour changes with stress. A few studies were carried on the activity of traders with the same result. A study from 2016 shows for instance that “stress conditions lead to decisions that can be described as more disadvantageous, more reward seeking, and more risk taking than nonstress conditions”.
Testosterone seems to add another dimension to our behaviour. It increases our optimism. Traders for instance were found to experience what has been coined as the “winner effect”: raising levels of testosterone relating to stress under market volatility lead to optimism about price trends. Taken together, cortisol affects the risk-appetite, whereas testosterone increases optimism about future price changes.
Acute stress and chronic stress have been found to bear different effects on brain activity and different implications. Indeed, studies show that persistently high cortisol is related to depressed mood. Relatedly, studies focused on traders’ activity have shown that persistent volatility leads to a normalisation of risk appetite (after the initial surge mentioned earlier). As John Coates puts it “Under conditions of extreme volatility, such as a crisis, traders, investors and indeed whole companies can freeze up in risk aversion, and this helps push a bear market into a crash.” Here comes another risk: “unfortunately, this risk aversion occurs at just the wrong time, for these crises are precisely when markets offer the most attractive opportunities, and when the economy most needs people to take risks”. Naturally, this doesn’t apply to financial markets only. Business leaders in any sector can fall victim to the same suboptimal decision making where they initially respond to a shock by taking more risk and, latter, if the crisis persists, succumb to it and slip towards irrational pessimism.
How can we manage our stress response to make the best decisions?
1. Avoid taking rushed instinctive decisions. Recognise when you feel pressure and deliberate your decisions. Look at your goals and see what worth be revised.
2. Have a risk appetite statement that you can refer to at all times. It can be as simple as a one sheet listing down all relevant risks and what is deemed acceptable. You can identify a key metric for each or at least put down what is deemed an unacceptable risk and what is acceptable and to what degree.
3. Mindset control. Lookout into techniques that help you control your mindstate and choose the stress coping strategies that fit you best. Act to keep your stress level under check.
4. Favour brainstorming sessions
5. Test your ideas before making an ultimate decision. Questions are great for opening up your mental frame and uncovering possible shortcomings. My preferred questions:
What will happen if …..
What will not happen if….
What will happen if I don’t…
What will not happen if I don’t ….