Do traders have instinctive biological mechanisms that drive them to predict how others behave, creating financial bubbles that lead to boom and bust? Researchers at Caltech (California Institute of Technology) think so.
Their study, which was published in the prestigious peer-reviewed journal Neuron, offers a unique understanding of the processes in the brain that influence financial decisions and behavior, leading to the creation of market bubbles.
The study is published exactly five years after the collapse of Lehman Brothers investment bank in 2008.
What is a “bubble”?
When active trading of assets or commodities reach prices that are significantly higher than their intrinsic value, that situation is known as “a bubble”. Market bubbles are invariably followed by a market crash.
The cycle of bubble and burst is more commonly known as “boom and bust”.
Recent examples of boom and bust include the U.S. ‘dot com’ sector and the UK housing market crashes. Both resulted in the loss of billions of dollars and pounds.
Bubbles, and their signaling of a prelude to a looming bust, have been researched extensively in economics. Experts are still not sure why they occur and then crash. We know even less about the biology of financial decision behavior.
Dr Benedetto De Martino, a researcher at the Royal Holloway University of London, England, was study leader while at Caltech.
Dr. Martino and colleagues set out to determine what biological mechanisms drive financial decisions. They brought together expertise in neuroscience and experimental finance to examine the behavior and brain activities of student volunteers as they traded shares within a simulated financial market.
The research team used fMRI (functional Margnetic Resonance Imaging), an MRI technique that also measures the flow of blood in the brain. A bit like an MRI scan that shows video movement rather than just still pictures.
By measuring the flow of blood in the brain, they were able to observe the volunteers’ brain activity in detail as they traded within the simulated market.
Are two areas of the brain drivers of boom and bust?
Dr. Martino wrote that he and his team detected a link between the formation of bubbles and greater activity in an area of the brain that processes value judgments. In an abstract in the journal, the authors wrote “social signals computed in the dorsomedial prefrontal cortex affect value computations in ventromedial prefrontal cortex.”
Social signals computed in one area of the brain affect value computations in another, resulting in boom and bust situations.
Those with increased activity in this area were more likely to ride the bubble and lose money by offering more for an asset than its intrinsic worth.
In bubble markets, the investigators also found a clear association between activity in the value-processing part of the brain and another part that is responsible for interpreting social signals to infer other people’s intentions and predict how they will behave.
Dr Martino said:
“We find that in a bubble situation, people start to see the market as a strategic opponent and shift the brain processes they’re using to make financial decisions. They start trying to imagine how the other traders will behave and this leads them to modify their judgment of how valuable the asset is. They become less driven by explicit information, like actual prices, and more focused on how they imagine the market will change.
These brain processes have evolved to help us get along better in social situations and are usually advantageous. But we’ve shown that when we use them within a complex modern system, like financial markets, they can result in unproductive behaviours that drive a cycle of boom and bust.”
The study authors reported that when the volunteers noticed a disparity between how much they thought an asset was worth and the rate of transactions for that asset, they started making bad business decisions, which invariably led to bubbles being formed in the market.
Co-author, Professor Peter Bossaerts explained “It’s group illusion. When participants see inconsistency in the rate of transactions, they think that there are people who know better operating in the marketplace and they make a game out of it. In reality, however, there is nothing to be gained because nobody knows better.”
Colin Camerer, Robert Kirby Professor of Behavioral Economics at the Caltech, said: “There’s a mathematical measure of when the flow of traders’ orders to buy or sell changes from steady to choppy. A choppy flow is a clue that trades are bunching up around new information or pausing to see what happens next. This way of measuring has been sitting on the shelf for years. This is the first study to show that it seems to correspond to what the brain is computing.”
Behavioral Economics is a branch of economics that includes elements of psychology to determine why humans, who tend to be irrational beings, make certain spending decisions.
This is the first study to provide us with a glimpse of what biological mechanisms occur in the brain that influence financial markets.
The study may not help us predict when bubbles are going to form, but it might help design better social and financial interventions to prevent future bubbles being formed in financial markets, the study authors wrote.
The study was funded by the Wellcome Trust, UK.