Is Homo Economicus Extinct?

By

John CoatesIs the notion of Homo economicus — an image of human beings as rational and narrowly self-serving actors — on its last legs? Two presentations on the opening day of the CFA Institute Annual Conference provided evidence to suggest that at the very minimum it should be on the endangered list.

Economic thought since the formation of modern portfolio theory has evolved considerably from the idea that economic decision makers are rational, do not display emotion, and seek to maximize economic profit in all situations. My 1980s economics textbook scarcely addressed human decision making and suggested that we can only predict human behavior at the group level (e.g., when winters are cold, people spend more money on heating oil).

But, according to Roland Ullrich, CFA, recent research into the brain has given us the ability to understand behavior at the individual level. He discussed work by Robert J. Schiller and Daniel Kahneman, among others, that suggests our brains are not optimized for financial decision making. Rather, human brains are optimized to make decisions based on a “fight or flight” response. Our state of mind greatly affects the way we look at risk. This is a significant departure from the idea that humans are perfectly rational beings.

“For humans, there is no pure thought,” John Coates said during his keynote address on “The Biology of Risk Taking.” Every thought causes an “echo” in the body, and Coates contends we can’t study decision making of any kind without thinking about the effects on the human body.

Ancient philosophers got it wrong: There is no such thing as dualism — a mind/body split. This notion of a split made its way into classical economic thinking, and thus, according to Coates, “Economics is based on a profound error.”

Coates took issue with the idea that humans have evolved to have larger heads and smaller bodies because our ability to reason is what pushed us to the top of the food chain. In fact, he argues, humans grew larger brains to support a more complex network of muscles. The brain and the body are not split; they work in concert.

Continuing in this vein, Coates discussed the effects of biochemistry on decision making. Stress is caused by three factors:

  1. Novelty (encountering something unfamiliar)
  2. Uncontrollability (randomly occurring external stimuli)
  3. Uncertainty (not knowing what comes next)

Stress activates a physical response. In the short run, adrenaline takes over. During longer periods of stress, however, our bodies produce the hormone cortisol. It shuts down long-term bodily processes, including digestion and the immune system, because presumably you do not need those in the face of imminent danger. Elevated levels of cortisol not only affect our bodies; they also affect the way we perceive risk. Studies show that elevated levels of cortisol make people more risk averse. Warren Buffett is famous for saying: “Be fearful when others are greedy, and be greedy when others are fearful.” Buffett wrote a New York Times op-ed in October 2008 after the credit markets collapsed titled “Buy American. I Am.” Many market participants are loaded up with cortisol after a significant market disruption — which makes Buffett’s advice difficult to follow.

Knowing that stress affects both body and mind, what should investment professionals do about it?

According to Coates, market disruptions cause stress, but a company management response to the market — cyclical hiring and firing — can cause even more stress. Investment firms are hard pressed to control volatility (a source of stress for traders), but they can adjust managerial responses to differing market conditions, which would help to reduce the level of stress in the workplace.

When asked about the difference between stress responses for men and women, Coates said that early theories suggested that because women produce less testosterone (the opposite of cortisol), they are not as subject to physiological swings under duress and therefore may make better traders. Coates said, however, that there is no difference in risk preference between men and women. The difference is in the type of risk they want to take. In general, women don’t like short-term, trading-oriented risk. They tend to prefer risk over longer periods of time, which may help explain why there are more women in asset management than trading — although absolute numbers are still very low. (Learn more about women and risk management at our upcoming conference Women in Investment Management.)

Coates closed his session with a slide he titled “Exit through the gift shop” and encouraged the audience to more fully explore his work by reading his book The Hour between Dog and Wolf.

If you liked this post, consider subscribing to the CFA Institute Annual Conference blog.


All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Photo credit: W. Scott Mitchell

This entry was posted in Behavioral Finance, Economics. Bookmark the permalink.

Leave a Reply

Your email address will not be published. Required fields are marked *