While most strategists talk about risk as a static factor, emerging research indicates that people’s penchant for risk-taking is quite changeable from moment to moment — and that may have major implications for Federal Reserve policy.
“Most models in economics and finance assume that risk preferences are a stable trait, much like your height. But this assumption, as our studies suggest, is misleading,” writes Cambridge research fellow and former Goldman Sachs derivatives trader John Coates in The New York Times. “Humans are designed with shifting risk preferences. They are an integral part of our response to stress, or challenge.”
Coates says that there is a major physical component to risk taking, which many people don’t realize. Increased stress, often caused by uncertainty, triggers the body to release the hormone cortisol, which studies have shown causes people to curtail risk taking. “Traders are immersed in novelty and uncertainty the moment they step onto a trading floor,” he writes. “Here they encounter an information-rich environment like none other. Every event in the world, every piece of news, flows nonstop onto the floor, showing up on news feeds and market prices, blinking and disappearing. News by its very nature is novel, adds volatility to the market and puts us into a state of vigilance and arousal.” Prolonged uncertainty and volatility thus leads to higher cortisol levels and decreased risk taking.
By broadcasting all of its moves and adjusting interest rates in a very planned, predictable fashion — something that it did not used to do — the Fed removes uncertainty and increases risk taking, Coates says. “There are times when the Fed does need to calm the markets. After the credit crisis, it did just that,” he writes. “But when the economy and market are strong, as they were during the dot-com and housing bubbles, what, pray tell, is the point of calming the markets? Of raising rates in a predictable fashion? If you think the markets are complacent, then unnerve them. Over the past 20 years the Fed may have perfected the art of reassuring the markets, but it has lost the power to scare. And that means stock markets more easily overshoot, and then collapse.”
The solution? “It may seem counterintuitive to use uncertainty to quell volatility. But a small amount of uncertainty surrounding short-term interest rates may act much like a vaccine immunizing the stock market against bubbles,” Coates says.