Wednesday, January 03, 2007

Excited about a Good Deal

(or "Why value investors really are passionate people")

In a fascinating new neurofinance publication in the neuroscience journal Neuron ("Neural Predictors of Purchases", Professor Brian Knutson (Stanford) and economist colleagues at Carnegie Mellon (George Loewenstein) and MIT (Drazen Prelec) set out to discover the brain areas that drive purchases of consumer items. This is one of the pioneering studies in neuroeconomics.

In the experiments, Knutson showed experimental subjects a series of routine consumer products (such as a box of Godiva chocolates) and the prices at which they could buy those items from the researchers. The prices of the items had been discounted approximately 70% from their retail prices. The discount was necessary because subjects had been unwilling to buy the items near the full retail price.

Knutson found that activity in three brain regions predicted purchasing decisions. Activity in the Nucleuas Accumbens (NAcc) was associated with a preference for a product (a desire to possess it), and predicted that the participant would buy the item. The participants’ medial prefrontal cortex (MPFC) was activated when prices were very cheap, and its activation also predicted that the subjects would buy. Decreased activity in the brain’s pain center, the insula, occurred during this experiment, and this decreased activity also predicted buying. In conclusion, it appears there are three neural predictors of buying consumer items – desire for the product (Nacc), a cheap price for the product (MPFC), and low price (decreased anterior insula - fear and pain - activation).

There are several speculative applications of these findings to investment practitioners. The joy value investors feel when they find bargain-priced stocks may be due to MPFC activation. Value investors such as Warren Buffett, David Dreman, and Bill Miller may be driven by such reward-based motivations.

Stock investors who look for an exciting or desirable story may be buying stocks based on NAcc activation. Investors who see little risk in an investment are driven to buy by the absence of a perceived “downside” (decreased anterior insula activation). All of these brain functions are helpful for investors to identify excellent opportunities in the markets, and for the most part they appear adaptice and biologically-based.

By integrating these findings with what we already know about consumer behavior, neuroeconomists are developing a more coherent picture of what drives different types of financial decisions.


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