Managing Wall Street's 'Winner Effect'

Wall Street is not known for self-examination. Colossally bad bets and spectacular losses are more often treated as individual failures than systemic ones; risky behavior is seen as a sign of intestinal fortitude, not foolishness. In the wake of the multibillion-dollar trading loss at JPMorgan Chase (JPM)—considered the best in the business at risk management—the financial industry has focused on who did what, when, and how big the losses might get. But that doesn’t explain why the firm’s traders and executives doubled down on a position that, in hindsight, looked clearly doomed.

What were they thinking? That question, in essence, is what John Coates has devoted his life to answering. Coates once ran a derivatives desk at Deutsche Bank (DB) in New York, until he decided he was more interested in trying to figure out why people are such poor judges of risk than he was in trying to profit from it. Now a senior research fellow at the University of Cambridge, he is employing the tools of neuroscience to identify the biological basis of what John Maynard Keynes called the market’s “animal spirits.”

In particular, Coates focuses on two hormones: testosterone, which increases our appetite for risk, and cortisol, which makes us shy away from it. Drawing on his Wall Street connections, he has been able to treat the trading floors of investment banks as his labs. The answers he’s finding could help financial institutions understand how the banking culture exacerbates the very tendencies companies should be guarding against. There may not have been a way to prevent JPMorgan’s “London Whale” from making his ill-fated bet on corporate bonds. But Coates’s research does suggest that the trader’s bosses should have seen the trouble coming.

Twelve years ago, Coates was flying home to New York from England and found himself sitting next to a young neuroscientist named Linda Wilbrecht. The two started talking. The dot-com bubble was reaching its high point, and what Coates was seeing around him on Wall Street had made him wonder about the chemical basis of the waves of exhilaration and despair that swept across the trading floor. Wilbrecht invited him to come by and view the work she was doing on how neurons form.

During lulls in the market, Coates started ducking out of Deutsche Bank’s midtown office and catching a cab up to Wilbrecht’s lab on the Upper East Side campus of Rockefeller University. He sat in on lectures and watched as she and her colleagues ran studies. After two years he quit finance and enrolled in the neuroscience Ph.D. program at the University of Cambridge, where he had years earlier earned a doctorate in economics.

The more Coates learned, the more he became convinced that traders were, as he put it, “a clinical population.” The stimuli of a trading floor triggered chemical changes in people’s brains, emotionally whipsawing them. During the tech bubble, he recalls, “People just really slipped their moorings: They were motor-mouthing, they weren’t sleeping, they were on this high. It was initially reasonable to assume it was cocaine, but I don’t know many traders that do that. There was something going on, it was just incredibly noticeable, and I realized that at times I had also felt that way.”

Coates is best known for a study he carried out in 2005. As he describes it in his forthcoming book, The Hour Between Dog and Wolf, he took saliva samples over a two-week period from 250 traders at a London firm, all but three of them men. At the same time, he tracked the profit and loss on their trades. He found that when a trader’s testosterone levels were particularly high in the morning, he went on to make more money than on days when his morning testosterone level was low. Coates calculated that on an annual basis, the differences between high-testosterone and low-testosterone days would add up to around a million dollars in take-home pay.

In species after species, biologists have documented something called the “winner effect.” When two male elephant seals or bighorn sheep fight over females, the victor gets a sharp spike in his testosterone levels, while the loser sees his dramatically drop. The theory is that elevated testosterone levels in the bloodstream of the winner—which in some species last for months—will help him in his next bout. Testosterone doesn’t just boost confidence, it raises the blood’s oxygen-carrying capacity and lean-muscle mass. With each bout the process repeats itself: The winner’s testosterone level keeps climbing, making him fitter, stronger, and more confident, and raising his odds of winning.

With enough victories, though, testosterone can reach levels that make the animal act foolishly. He picks fights he can’t win, tries to claim too much territory, and roams around in the open where predators might pick him off. A human being on a trading floor might take massive, risky bets on the strength of the American housing market or on U.S. corporate bonds. One of the traders Coates studied went on a hot streak, making twice his average profit-and-loss ratio for five days in a row. By the end of it his testosterone levels had risen 80 percent. If Coates had followed the trader long enough, he believes, there was a good chance “he would be irrationally exuberant and blow up.”

For losers, the effect is the opposite: The stress and worry of losing money cause the endocrine system to flood the body with cortisol, which makes people afraid to take even favorable bets. In the wake of a financial crisis, it’s not just Wall Street traders who suffer from this, but anyone making decisions about money, whether it’s an employer who balks at hiring or a bank officer leery of making a loan even when the Federal Reserve is offering her free money to do so.

Coates’s work reinforces the findings of behavioral economics, which looks at how actual human behavior—even that of financial professionals—fails to match up with the classical economic assumption that people are utility maximizers, dispassionately calculating costs and benefits. Because Coates focuses on biology rather than just behavior, his research suggests how these tendencies arise and a few ways we might better corral them. For one thing, he encourages financial firms to educate their employees about the effects hormones have on decision-making. “Traders need to be trained so they can recognize and handle the physiological changes resulting from their gains and losses, and from market volatility,” he writes. Traders conditioned to spot the manic behavior of the winner effect might be more wary about taking risks they otherwise would have unthinkingly embraced.

To reduce volatility, banks should also strive for a sort of hormonal diversity. Testosterone levels decline as men enter middle age, and women have 10 percent to 20 percent the testosterone levels of men; both groups, Coates argues, should be better represented on trading floors. In his book he points to a study by the economists Brad Barber and Terrance Odean that shows that single women investors outperform single men over the long term (because they tend to trade their accounts less). Another study by Chicago-based Hedge Fund Research shows that hedge funds that were run by women significantly outperformed those run by men.

Whether this strategy would have saved JPMorgan its recent embarrassment is unclear. Ina Drew, the banker overseeing the office where the bad trades were made, is a woman—though, according to the New York Times, she was ill when the groundwork for the trades was being laid. Two of the strongest internal critics of the trades were women as well. (Coates is currently studying whether women are susceptible to the winner effect.)

At the very least, Coates says, JPMorgan should have been aware that it was fueling its employees’ most counterproductive hormone-driven tendencies. Risk management systems at many banks give traders more leeway during bull markets and rein them in during bear markets. Compensation schemes similarly reward each year’s winners and punish the losers. As a result, traders on a winning streak are allowed and encouraged to take on the most risk at exactly the time their biology is already pushing them toward recklessness. When the market turns, traders already gun-shy from cortisol are discouraged from taking any risk whatsoever, extending the downturn. Better, Coates says, to calculate pay based on longer timelines (a suggestion that plenty of non-neuroscientists have also proposed).

As for risk management, banks should start paying closer attention to those traders who are on a roll. “We have to start thinking of management as leaning against these tendencies, stabilizing the biology,” Coates says. “Risk management should be looking at the stars. They’re always the ones who succumb to this winner effect and end up blowing up the bank.”

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Chia Seeds, Wall Street's Stimulant of Choice

Christine Kenney, a triathlete who works the equity capital markets execution desk at Citigroup (C) in Manhattan, starts every morning at work with a bowl of low-fat yogurt, honey, and a heap of chia seeds. Throughout the day she subsists on chia snack bars. “It’s better for my job because I’m not supposed to be off the desk very much,” she says, noting how she’s gotten most of the co-workers from her desk hooked on the seeds. “There’s other seeds out there that are nutritious, but this is the best. It’s the alpha seed.”

Photograph by Alexey Kamenskiy/ShutterstockChia seeds are more or less flavorless

Among Wall Street’s trading desks and bullpens, chia seeds are becoming the stimulant of choice. Healthier than coffee, cheaper (and obviously more legal) than cocaine, and less juvenile than a 5-hour Energy drink, chia has undergone a total metamorphosis from 1980s punchline (Chia Pet’s “ch-ch-ch-chia” jingle still haunts Gen Xers) to superfood.

Credit for chia’s second coming belongs partly to the 2009 bestselling book Born to Run by Christopher McDougall, about a remote Mexican tribe of marathon-running Tarahumara Indians who have been bullish on chia since Aztec days—eating it ground, mixed into drinks, or raw. After reading it, Dan Gluck and Nick Morris, a manager and trader at a New York hedge fund, began supplementing their post-workout breakfasts with chia seeds, rich in protein, fiber, and omega-3 fatty acids. They spread the chia gospel to friends in finance and soon had a following. In 2011 they launched Health Warrior, which markets chia seeds and snack bars boasting chia’s purported benefits, from sustained energy to enhanced focus and better digestion.

While research on those benefits is relatively sparse, Wall Street chia heads aren’t waiting for further studies. “Instead of snacking on the trading desk, I will make a chia smoothie or grab one of their Health Warrior Chia Bars,” says Jason Feinberg, managing director of U.S. equity trading at Barclays Capital (BCS). Shane Emmett, Health Warrior’s chief executive officer, says an investment bank and a hedge fund have begun buying in bulk. “I’m sure the ‘warrior’ speaks a little bit to the aggressive nature of folks on the Street,” he says.

Sax is a Bloomberg Businessweek contributor.

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Wall Street's Favorite Democrat

(Wording is altered from the print version.)

Wall Street doesn’t have many friends in Washington these days—especially among Democrats on Capitol Hill. They pushed through the massive Dodd-Frank financial overhaul and are scrutinizing derivatives trading and similar high-risk practices.

There is one House Democrat who’s shown some sympathy for Wall Street: Jim Himes. A former Goldman Sachs (GS) investment banker who represents Greenwich, Westport, and other affluent Connecticut towns where many bankers rest their heads at night, he isn’t shy about defending the industry or decrying Wall Street bashing. Banking policy has devolved into a “morality play that is good vs. evil, Democrat vs. Republican, which is absurd,” he says. Dodd-Frank “contains some very, very good things and very important things. And it contains some silly things.”

From his seat on the House Financial Services Committee, Himes has sided with Democrats in resisting Republican calls to repeal Dodd-Frank—which he helped to write and voted to pass—but he’s also joined with Republicans who argue the law puts the industry on too short a leash. This year, he has authored legislation to limit the ability of regulators to oversee international swaps trades, and worked out a deal between the parties to water down requirements that financial firms keep their derivatives deals separate from their federally insured banks. He has also leaned on regulators to ease restrictions on the speculative trading banks do for their own accounts.

No surprise that Himes’s efforts win him kind words from Wall Street. “He brings real-world experience to the table,” says Scott Talbott, chief lobbyist for the Financial Services Roundtable, an industry trade association. “He’s somebody we can work with.” Of the $1.7 million in campaign contributions Himes has amassed to fund his campaign for re-election, nearly $219,000 has come from the securities and investment industry, according to the Center for Responsive Politics.

He’ll likely need all the cash he can get: Republicans have put Himes on their hit list of potentially vulnerable House Democrats targeted for defeat in November. “We plan to hold Jim Himes accountable for his record supporting the president’s big government tax-and-spend agenda,” says Nat Sillin, a spokesman for the National Republican Congressional Committee.

Himes’s Wall Street cred isn’t enough to make Republicans forget that he is otherwise a reliable Democrat who backs President Obama’s health-care reform law, favors tough environmental regulations, and believes his GOP colleagues are kidding themselves if they think they can reduce the deficit without raising revenue. It probably doesn’t help that Himes can’t seem to keep his thoughts to himself. An avid Twitter user, @jahimes rarely misses a chance to poke Republicans in the ribs, including House Majority Leader Eric Cantor—a politician not noted for his sense of humor. “So you can support Cantor’s bill or you can be serious about taming the deficit. But you can’t do both,” Himes tweeted on April 20. (He says his staff has laid down the law: no mention of body parts, and no tweeting after more than two drinks or less than four hours of sleep.)

Himes, who won his seat four years ago by defeating a veteran Republican, knew he’d have to fight to keep it. Though he’s personally popular and his district leans Democratic, it’s expected to be a close race. “I gotta be at Rotary clubs, I gotta be at American Legions, I gotta be at people’s events,” he says. “I look at the lifestyle of someone who has a safe seat and I crave that lifestyle, but it’s not good. The country would be a lot better off if everyone’s district looked like mine. I always have to be on my toes.”

The bottom line: Despite Himes’s willingness to buck his party and push bills to ease restrictions on big banks, the GOP has targeted him for defeat.

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Now, Wall Street's a Different Place

Illustration by Pete Ryan

By Max Abelson and Ambereen Choudhury

On the June day that Michael Reiner lost his job as a credit strategist for Societe Generale in New York, he turned in his cell phone, visited a nearby store to replace it, and called his wife. She was at their home in Briarcliff Manor, N.Y., watching The Company Men, a film about corporate downsizing. He was shocked, he says, by the way his job “simply came to an end.”

The 44-year-old former managing director was caught up in a wave of firings that will wash away more than 220,000 jobs in the global financial-services industry this year, eclipsing 174,000 dismissals in 2009, data compiled by Bloomberg show. Almost every week since August has brought news of firings. HSBC Holdings, Europe’s biggest lender, announced that month it would slash 30,000 jobs by the end of 2013. In September, Bank of America, the second-largest U.S. lender, said it too would cut 30,000. Both banks are trimming about 10 percent of their workforces. In November, BNP Paribas, France’s largest bank, said it will cut about 1,400 jobs at its corporate and investment-banking unit, and UniCredit, Italy’s biggest, said it plans to eliminate 6,150 positions by 2015. “This is a structural change,” says Huw Jenkins, a London-based managing partner at Brazil’s Banco BTG Pactual. “The industry is shrinking.”

Faced with higher capital requirements, the failure of exotic financial products, and diminished proprietary trading, the industry may be experiencing more than a cyclical dip. “At many firms, a lot of investment bankers have been convinced that we are living now in a limited period where things are a bit more difficult, and afterwards the old world will come back,” says Kaspar Villiger, chairman of Zurich-based UBS. “This illusion has now vanished.”

Banks, insurers, and money management companies in North America have announced 50,000 job cuts this year. That’s more than twice last year’s total, though fewer than the 175,000 in 2008. Wall Street won’t regain its lost jobs “until about 2023,” Marisa Di Natale, an economist at Moody’s Analytics, said in an e-mail, adding that former Wall Streeters will have to find employment in healthier corners of finance or “go to other industries altogether.” Steven Eckhaus, chairman of the executive-employment practice at Katten Muchin Rosenman in New York, says that with the job outlook so grim he has stopped giving his “spiel” to clients about inherent talent leading to new work.

Financial companies in Western Europe have announced about 125,000 dismissals this year, almost double the region’s losses in 2008 at the depths of the financial crisis, Bloomberg data show. Head count in the City and Canary Wharf financial districts of London may fall to 288,225 by the end of the year, 27,000 fewer than in 2010 and the lowest since at least 1998, when there were 289,666 jobs, according to the Centre for Economics and Business Research in London. “It’s a once-in-a-generation challenge,” says John Purcell, founder of executive search firm Purcell & Co. “Everyone who has worked in the City since 1985 will have no idea of how to cope with this level of dislocation.”

In interviews, a dozen people who have lost jobs at Lloyds Banking Group, Royal Bank of Scotland, Jefferies, and other firms described growing pessimism about their prospects. For Reiner, being let go by Societe Generale was his second job loss in four years. He worked at Bear Stearns for 14 years until the firm collapsed in March 2008 and was taken over in a fire sale by JPMorgan Chase. When he began looking for work after that, he says he “wanted to find a place for the next 14 years.” It’s harder to talk about losing a job the second time, he says: “There are a lot of people I haven’t told.” Now he spends his time going to his daughter’s field hockey games and managing his investments. He plans to pursue his hobby of making maple syrup from the trees in the backyard of his home.

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