Stress test – The experiment that suggests stress can cause short-term changes to risk tolerance


Jamie Lowry

Jamie Lowry

Fund Manager, Equity Value

How much or how little risk someone is prepared to tolerate as they seek to grow their wealth is seen as one of the more fundamental considerations in investment. Implicit within this belief is the assumption that, once a person has decided where they fit on a spectrum that traditionally runs from ‘cautious’ to ‘adventurous’, this attitude to risk will remain constant unless their circumstances materially change.

According to a recent academic study, however, people’s risk preferences are by no means as stable as is generally thought. Led by Narayanan Kandasamy, Ben Hardy and Lionel Page, a team of Cambridge-based researchers artificially raised the stress levels of their volunteer test subjects and found this led to their becoming more risk-averse.

In a previous study, the researchers had observed that professional stock traders registered a sustained rise in cortisol – the hormone secreted by the adrenal glands at times of stress – when they experienced increased uncertainty in the shape of market volatility. This prompted the team to wonder whether such a rise in stress might lead to any change in risk appetite.

To investigate this idea, they administered hydrocortisone, the pharmaceutical form of cortisol, to one group of test subjects over a period of eight days while giving a placebo to a second ‘control’ group. The initial dose of hydrocortisone was an ‘acute’ one – raising cortisol levels versus the control by some 250% – while thereafter a daily ‘chronic’ dosage raised levels by some 68% versus the control.

This second dose was deliberately set at 68% with a view to replicating the changes in cortisol levels the team had previously observed in their study of the professional traders. To ensure a sustained level of cortisol, participants took tablets three times a day and the results were monitored through saliva samples collected from both the hydrocortisone and control groups.

All the subjects where given a number of risk scenarios to see how the choices of the hydrocortisone group compared with those of the control group. Each scenario involved participants stating which of two lotteries they would prefer to play, with each lottery offering different chances of winning different amounts of money and sometimes nothing.

In the table below, for example, the participants were asked to choose between lottery c, which offers a seven-eighths chance of winning £60 and a one-eighth chance of winning £90, and lottery d, which offers a five-eights chance of winning £90 and a one-quarter chance of winning £60 but also a one-eighth chance of ending up with nothing. So which of the two would you prefer to play?

Source: Cortisol shifts financial risk preferences, Institute of Metabolic Science, University of Cambridge and National Institute for Health Research, 30th December 2013.


If you are risk-averse in nature – at least today – it is likely you chose lottery c as, while lottery d’s expected pay-off is greater, it also offers a chance of ending up with nothing. certainly what the researchers found was a test subject was far more likely to pick the less risky option after a sustained (chronic) increase in cortisol compared with either the control group or a large, one-time (acute) hit.

Translating that into an investment context, the results of the experiment suggest that while investors may be able to deal with a one-time traumatic event such as a large market fall, a sustained period of market volatility will serve to make people more risk-averse over time. If so, this would have significant implications for financial markets and economic theory.

For it would indicate that people do not make rational decisions based on risk preferences that are constant over time, as the branch of economics known as ‘rational expectations theory’ argues, but more – as George Soros’s ‘general theory of reflexivity’ suggests – that people are actually a function of their environment and, as such, their risk preferences change in response to the outside world.

Thus, when markets grow more volatile, investors become less willing to take on risk, which in turn makes the world look more depressed and so investors grow more concerned and so on and so forth. Such behaviour exacerbates market cycles and is the reason investors have to cope with the despondency that accompanies the market’s troughs and the euphoria that accompanies its peaks.

Kandasamy and Co’s experiment is a striking example of how, as Warren Buffett put it, “investing is simple but not easy”. All value investors know the importance of looking to sell when markets are euphoric and buy when everyone else is despondent and yet it turns out this is challenging not only behaviourally but also neurologically as our brains may actually be hardwired against it.



Jamie Lowry

Jamie Lowry

Fund Manager, Equity Value

I joined Schroders in 2004 as an equity analyst in the European Equity Team initially specializing in the Industrial sectors before moving on to Consumer-based companies and finally Insurance. In 2007, I became a co-manager on a fund investing in undervalued European companies and took on sole responsibility for the fund in May 2010. Prior to joining Schroders, I worked at Hedley & Co Stockbrokers and Deutsche Asset Management as a trainee analyst.

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