Our spending habits can be irrational. Despite mainstream economic theories of financial decision-making as a purely rational process, most of us can admit that we’ve indulged in an extra Starbucks coffee, a designer wristlet, or a useless iPhone app for $0.99. We impulse-buy. And in a recent article published in Psychological Science in the Public Interest, Tommy Garling and his associates present compelling evidence for the irrationality behind financial decision-making: a rational approach to economics could not predict the current global financial crisis. Number-crunching alone wasn’t enough.
But if university students and Wall Street traders alike make irrational spending choices, what drives these risky decisions? Why wouldn’t the rational part of our brain take control?
According to Garling and trader-turned-neuroscientist John Coates, the author of The Hour Between Dog and Wolf: Risk-taking, Gut Feelings and the Biology of Boom and Bust, rational economic theorists forget one crucial thing about spending choices: we are, and forever will be, vulnerable to the biology of our bodies. And because our bodies act impulsively, we make irrational decisions.
“Economics has always assumed that it’s a purely cognitive activity—economics from the neck up,” says Coates in a National Post article. “I think that’s fundamentally flawed thinking. Because when we take risks, our entire body participates in the process.”
So what goes on inside our bodies when we swipe our credit cards, bet on the Leafs, or however we like to spend our money?
In his article, Garling explains that in extremely stressful market situations, a trader might lose their capacity to make “rational judgments and decisions”. We can see this as people trade to excess and as stock prices swing up and down. It’s a risk. Traders often rely on cognitive biases like overconfidence, undue optimism, or the conviction that something is a sure gain or a sure loss. In other words, traders are human.
But in his book, Coates digs deeper and hypothesizes that it’s the rise of testosterone in traders that creates these swings of confidence. In the National Post article, Coates describes how he watched his fellow traders become “delusional” and “euphoric” as they were overtaken by “racing thoughts [and] diminished need for sleep, and were putting on ever larger trades with worsening risk-reward tradeoffs”. Much like when we engage in outrageous shopping sprees or splurge on an expensive item, Coates watched “normally prudent people” become “crazy”. Coates attributes this transformation to the surge of testosterone in a trader’s bloodstream. He calls this transformation “the winner effect”. According to the winner effect, when an animal wins a fight for territory, that animal is statistically more likely to win its next fight. This is because after the first win, the animal’s testosterone level rises. This rise not only increases the animal’s lean muscle mass and capacity to carry oxygen in its bloodstream, but affects its brain as well. The surge in testosterone produces a feeling of confidence and an urge to take more risks. Andrew Sullivan, a New York Times journalist, once described the effect of testosterone on the brain thus: “My wit is quicker, my mind faster, but my judgment is more impulsive. In a word, I feel braced.”
Coates’ perspective on the biology of risk-taking is speculative. But it’s still easy to picture the winner effect as it plays out in our everyday lives. Consumer confidence can lead us to swipe our credit cards without thinking of the cost. It can also lead us to make bets on fantasy football teams, gamble in poker, or continue shopping at Aritzia after the first great purchase.
But Coates and Garling suggest that an awareness of the biology behind spending may help us recognize and eliminate our irrational choices. “When you take risks,” Coates writes, “you are reminded in the most insistent manner that you have a body.”
