Thursday, June 30, 2005

Neurofinance Is What?

I'm often asked questions of the sort, "What are the tangible, practical applications of neurofinance?"

Quick answer:
1. Helping people make better financial decisions.
2. Finding and exploiting irrationalities in the financial and business markets.

Expanded answer:
1. Diagnosing individual differences in financial decision making (e.g. looking at who is better and worse at certain financial scenarios, and why (it's in the brain)). Then customizing biological and psychological interventions to improve their decisions.
2. Looking at what type of information activates people's hardwired neural circuitry (e.g. what makes them more or less risk averse?). Then examining how that shared group processing affects financial and business markets (e.g. guides the search for financial market anomalies).
3. Discovering how people's unconscious neural states predict their behavior. Then looking at what activates different neural states (e.g. sunshine makes dopamine release increase in the brain's neurons, subsequently we feel happy, and the stock market goes up since we become less risk averse when happy and dopamine-infused).

Longest answer:
The question "What is neurofinance?" is arguable. "Neurofinance" sounds good - the word connotes the cutting-edge - something technological, futuristic, and potentially lucrative. But in its way, "neurofinance" is 'all hat and no cattle' (as my Texan relatives might say) - the word looks slick but doesn't have any obvious scientific backing.

In general, neurofinance refers to neuroscience and psychology studies of traders, investors, and pretty much anyone who is making financial decisions. You may wonder, "have there been many of these studies?" Good question. The answer is sadly no, not at all.

If you look through the body of scientific research and published data regarding neuroscience and economics, you won't find any studies with directly commercializable results.

Given the potential profits to be derived for any business that can understand the mechanisms (and errors) of financial decision making, you might feel incredulous that very little research has been done in this vein.

Part of the reason for this ommission lies in the fact that finance researchers have only recently (within the past 15 years) stopped arguing about whether individual irrationalities are reflected in market prices or in important business decisions. Now that we have stopped arguing and accepted that YES they are there, the fields of behavioral finance and behavioral economics have moved into the mainstream in business schools. Now that we all agree there might be something useful for finance through an understanding of psychology, who's going to do the research?

Many researchers have been stymied by the lengthy learning curve required to master the new neural research technologies such as positron emission tomography (PET), functional magnetic resonance imaging (fMRI), electroencephalography (EEG), and psychophysiological techniques. Studies of patients with specific neural lesions are similarly difficult to organize.

Searching for the origins of rational and irrational financial decisions often requires interdisciplinary research between finance, psychology, and/or medical researchers. When we aggregate subjects and look at general trends in their behavior, we do find that most people, on average, make specific financial errors over and over again - these are presumed to be inescapably hardwired (neurally-based) mistakes. This blog will discuss these errors (a.k.a. cognitive and emotional biases or heuristics), and what you can do to prevent and manage them, in later postings.

Andrew Lo and Dmitry Repin at MIT have published the most relevant data regarding neurofinance. They studied the physiology of traders (The Psychophysiology of Real-Time Financial Risk Processing). They found that periods of market volatility cause physiological reactions (increased cardiac volume and skin conductance), especially in less experienced traders. Physiological reactions indicate that adrenaline and other stress hormones and proteins have been released by the nervous system. To simplify, traders are stressed out by market volatility. "Big deal," you may say, "I already knew that."

Lo and Repin then found, in a second study, that the most emotionally reactive traders have the worst trading results. Intriguingly, they also found that traders with the least emotional reactivity also have diminished results. Moderate emotionality is optimal for successful trading.

Every other good study in the field of "neurofinance" is under review for publication. Some interesting correlations can be drawn from among other research, but the sum total of the pure neurofinance studies published so far are the two by Lo and Repin, and those studies don't even look at brain activations.

A study that should be coming out soon does look at brain activations using fMRI, and it's results are stunning. Stay tuned for its publication, hopefully this Fall.

In future posts I'll discuss some of the latest research in neuroimaging and how it relates to trading, investing, and saavy money management. For more info, check out:


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