Do traders with high levels of testosterone have a better track record in financial markets? John M. Coates of the University of Cambridge and Lionel Page of Westminster Business School have tried to provide answers to that rather strange question. Researchers have long considered that what they call the 2D: 4D ratio, or the ratio of the lengths of the second and fourth digits (the index and ring fingers) as a measure of pre-natal androgen exposure, androgen being the generic term for hormones that primarily influence the growth of the male reproductive system—testosterone being the predominant androgen. Wikipedia says “That a greater proportion of men have shorter index fingers than ring fingers than do women was noted in the scientific literature several times through the late 1800s”. A lower 2D:4D, say the researchers, or a longer ring finger relative to the index finger, has been found to correlate with higher levels of foetal testosterone. Coates and Page analysed the profit and loss statements of 53 male high-frequency traders on a trading floor in the City of London over a 20-month period between 2005 and 2007. Since these traders traded mostly European futures contracts and especially the German market, they compared the performance of the traders with the Dax, the German stock market index. They found that the Sharpe Ratios (or the risk-adjusted returns) for experienced traders were higher than that for the Dax, while the Sharpe Ratios of the beginners were not significantly different from that of the Dax.
In an earlier study, Coates and Page had found that lower 2D:4D (or higher testosterone) among high frequency traders predicted higher long term profitability and a greater number of years of survival in the business. That’s because, say the researchers, the androgens may increase risk preferences, confidence, speed of scanning data, or physical reactions. Could the higher Sharpe Ratios be the result of higher testosterone levels? A series of tests showed that “the low 2D:4D traders are more profitable and survive longer in the markets, as was previously reported, but we now find the effect is largely mediated through a higher tolerance for risk.” In other words, high testosterone traders may welcome more risk, but their return per unit of risk is not very different from the rest. So testosterone cannot explain the high Sharpe Ratios. So what does determine the higher returns? Coates and Page found that Sharpe Ratios increase over time because traders learn to make more money per unit of risk that take. Simply put, it’s trading experience that counts.
The scholars point out that this is at odds with the Efficient Markets Hypothesis (EMH), which basically says that traders and asset managers cannot beat the market. Other researchers too have challenged the EMH, one of them being a study of profitable day traders in the Taiwan stock market. The Coates and Page paper, by stating that experienced traders have better risk-adjusted returns and consistently beat the market, also goes against the EMH. So does their conclusion that trading performance is improved by experience and training.
Illustration: Jayachandran / Mint
Point out the researchers, “The results presented here may conflict with the assumptions of the Efficient Markets Hypothesis, but they accord with common sense. Traders are risk takers so need a high tolerance for risk, a trait predicted by a measure of prenatal androgen exposure. However, this trait, like height or speed in sports, may count for little without proper training and management. In trading, as in sports, biology needs the guiding hand of experience.”
But was the traders’ outperformance restricted to the boom years of 2005-07? Did they fail miserably in the crash of 2008? Coates and Page had the same doubts, which is why they asked the managers at the firm where they had carried out the study about the performance of their traders. The answer: “The managers provided data showing that the experienced traders remaining at the firm during 2008 made on average more money than they had during the study, with many of them having record years.” The moral of the story: testosterone plus experience=successful trading. But it wouldn’t be a surprise if broking firms start checking the length of the ring and index fingers of their personnel before assigning them to the trading desk.