Now that we have realised that boom, and particularly bust, are very much still with us, attention has turned again to why bubbles in financial markets happen. Some reasons are to do with the incentives facing traders, for example, if they are rewarded for high short-term profits. Hormones are another avenue of research, with studies showing links between testosterone and risk-taking behaviour.
A recent study by neuroscientist John Coates suggests that testosterone could increase the bubbliness of markets. When traders are on a winning streak, their testosterone levels surge, and the resulting euphoria leads them to under-estimate risk. In contrast, when stressed, traders are overly fearful and over-estimate risk. Apparently, because women have about 10% as much testosterone as men, they are less prone to irrational exuberance. (How the tables have turned since the days of the suffragettes).
Apart from hiring more women, another thing that firms could do is to get traders to work in teams rather than on their own. In the paper “Two heads are less bubbly than one”, Stephen Cheung and Stefan Palan from the University of Sydney describe their recent study on the behaviour of traders working in pairs instead of as lone wolves. They find that bubbles and crashes are smoothed out when decisions are made in teams of two – even when those taking part were more experienced.
Why this happens is a question that isn’t answered here. An interesting follow-up study would be to check the effect of testosterone levels on the behaviour of different pairs. For example: would pairs combining a low-testosterone trader and high-testosterone trader be better than pairs of traders that both had high testosterone? Would a pair made up of two high testosterone traders be more bubbly than one?