Richard
L. Peterson, M.D.
Market
Psychology Consulting
San
Francisco, CA USA
Email: richard@peterson.net
Probing the brain of an
investor: How advances in neuroscience
are demystifying the markets
Episodes
of extreme market volatility demonstrate the role of emotion-based trading
in moving stock and commodity prices. The
internet stock bubble is an obvious example of emotions overtaking investors’
“common sense.” More recently, the
extreme moves of currency (e.g. USD) and commodity (e.g. gold and oil) prices
prior to the invasion of Iraq in March 2003 illustrate the influence of anxiety
in driving prices. The power of the
field of behavioral finance lies in its ability to predict and explain such
emotion-driven price movements.
Behavioral
finance encompasses the study of both repeating market patterns and “irrational”
investor behavior. The discoveries
of behavioral finance are descriptive. Understanding simply that a price pattern exists in the markets
is much different than understanding why that pattern exists. In order to gain a deeper understanding of
what moves investors and markets, recent research has turned its focus toward
studying brain processes themselves.
Studies
of the brain (neuroscience) are teaching us how, why, and when investors make
decisions to buy and sell. If we know
what information and emotional states will stimulate buying or selling, then
more accurate (and profitable) forecasting models of the markets can be developed.
There are many applications of contemporary neuroscience research directly
to investors participating in the financial markets.
Our
primary goal is to understand the neural basis of investors’ buying and selling
decisions. On a large scale, this
understanding will help us to create better market models (to ultimately reduce
both price inefficiency and the risk of market crashes). Individually, we can help investors decide
what type of money-management strategy fits their unique personalities.
NEUROIMAGING
Advances
in neuroimaging technology allow us to see what happens in the brains of people
who are faced with risky financial choices.
Neuroimaging technology provides a tantalizing view of the origins
of investing behavior in the brain. We
can witness how information drives investing and how individual differences
(such as personality) influence investing profitability.
REWARD SYSTEM
In
order to understand the importance of neuroimaging to investors, some background
information is helpful. We must first
emphasize that the potential of profit is what motivates investing.
In general, investors are motivated by money, and they will invest
in those securities that they anticipate will produce the highest return over
a given time. Investors (ideally) place trades when they
believe that their potential profit will outweigh their potential loss.
Investing
is a profit-seeking (reward-seeking) behavior.
Investing is actually similar to other types of reward-seeking behavior
such as the pursuit of tasty food, pleasure-inducing drugs, and sex. Reward-seeking behaviors are generated in an
area of the brain deemed the “reward system.” This system
can be seen in action with neuroimaging scans.
The
reward system has several functions. The
reward system assesses reward values, prioritizes resource and energy expenditure,
and motivates behavior to procure the most valued rewards. Of course, we don’t always know which rewards
will be the most lucrative. To obtain
the most lucrative rewards, optimum balance of the system is essential.
INDIVIDUAL DIFFERENCES
A
variety of personality styles exist. It
turns out that different personality traits are better suited to assessing and
pursuing rewards in different environments.
Depressive people are better at analyzing details and thinking through
problems slowly and deliberately.
Neurotic people have trouble making decisions and dealing with
ambivalence (and may overtrade in sideways markets). Extraverted people feel more positive and act more decisively
towards potential reward than others.
In general, extraverts are more likely to jump at potential
opportunities without gathering background information (e.g. more likely to buy
internet stocks during the bubble).
Researchers have found that whether we pay too much attention to
potential gains, potential losses, or have a balanced view of both is
determined by our biological “hardware.”
Personality
traits determine how one responds to risky situations, new opportunities,
and gain and loss. In the future,
neuroimaging techniques may help us diagnose and target interventions for
poor financial deicion making. Someday soon we may even be able to identify
individuals as superior long-term or short-term traders. We will also be able to evaluate and rank portfolio
management candidates. FMRI research by Brian Knutson and Camelia Kuhnen at
Stanford University is investigating these concepts.
FEELINGS
There
are several global characteristics of the reward system across individuals.
We can see, in the brain, how different presentations of rewards create
positive or negative feelings. We can assess the effects of reward predictors
(cues), reward probability, reward magnitude, and risk and uncertainty on
decision-making. Reward predictors
themselves activate a brain region associated with both positive feelings
and high energy (excitement). Reward predictors create an energetic, pleasant feeling that motivates
behavior for reward pursuit. This
pleasant, energetic feeling is the result of increased levels of a brain chemical
called dopamine.
DOPAMINE
Dopamine
makes people feel positive, confident, and energetic. Both cocaine and amphetamines (the U.S. Air Force’s “go” pills)
increase brain levels of dopamine.
Using neuroimaging we have found that areas of the brain that release
dopamine become more active during the anticipation of reward. More dopamine is released if larger rewards
are anticipated. However, receiving an
expected reward actually depresses brain dopamine levels (and positive
feelings) slightly from during the period of anticipation.
EXPECTATION OF REWARD
The
anticipation of getting a reward makes investors feel good. Among securities, past price performance does
not predict future returns, but it does increase our expectations of
future returns. Additionally, as a previously owned security rises, investors
feel positive, and are more confident in their investing abilities. Expectations have a tendency to rise higher
and faster than they can be fulfilled. Expectations,
when achieved, spawn higher expectations until a breaking point is reached
and disappointment becomes inevitable.
From
our neuroimaging studies we find that receiving a reward is not as satisfying
as the anticipation of it. Investors
whose investments meet their performance expectations will often feel less
positive, and more risk averse, after their expectations are met. When people anticipate a reward that either
does not occur when expected or is less than expected, they will feel disproportionately
disappointed.
One
investing example is product releases.
Investors often buy corporate stock before the release of much-hyped new
products and then sell the shares following the release (“buy on the rumor and
sell on the news”); e.g. Pixar stock drops immediately after new movie releases
and Apple stock drops after Macworld tradeshows (Tam, Wall Street Journal, 2001
and 2002). Another example is the
performance disparity between growth and value stocks. Value stocks historically have outperformed
growth stocks, perhaps because they don’t have an expectation of “growth”
already priced in. In general this
expectation of growth is more easily disappointed than the neutral to negative
expectations accompanying value stocks.
SEROTONIN
Disappointed
expectations, such as result from repeated investment losses, depress brain
serotonin levels. Decreased brain
serotonin levels are associated with serious emotional and behavioral consequences,
such as feelings of anxiety, depressed mood, increased impulsivity, and irritability.
These emotional states are biological protective mechanisms. Anxiety and depression paralyze investors,
preventing them from taking investment risk.
Impulsivity results in the investor trying different investing strategies
(usually off his system) and over-trading in the frantic search for a profit.
Unfortunately for investors, emotionally-speaking losses are weighted
negatively twice as heavily as gains are weighted positively (Kahneman and
Tversky, 1992). Given the double impact of losses, short-term investing (trading)
can be an inherently self-destructive activity (unless investors can profit
on more than two-thirds of their trades or not grow accustomed to expecting
success).
Gambling
and other addictive behaviors may be the result of a potent brain cocktail of
decreased serotonin and increased dopamine.
Cocaine, amphetamines, and anticipating the “next big win” all make us
feel more confident and happy by increasing our brain’s dopamine levels. Unfortunately, when that big win doesn’t pan
out, we feel doubly negative as our serotonin levels drop. Now we’re more impulsive, depressed, and
nervous. The only way we know how to
get out of this negative state is to find another big reward to
anticipate. Again, anticipation of
reward now results in increased feelings of confidence and well-being that mask
our deeper depression (low serotonin).
The positive feelings of reward anticipation, by briefly relieving our
chronic depressed mood, are psychologically addictive.
VALUATION OF REWARDS
In
addition to reward anticipation, valuation is performed by the reward system.
Valuation of rewards is affected both by the time distance until the
reward (less priority to the more distant rewards) and by a higher number
of potential rewards (less attention available to assess each possibility).
Neuroimaging allows us to see what choice options are most valuable
to people. For example, if offered
a choice between two rewards (a sports car or a limousine in one study), the
brain will be more activated by the favored option (the sports car) (Erk et
al, 2002).
The
brain’s valuation function is relevant to theories of options pricing. For example, options premiums account for the
price uncertainty that exists between the present time and their expiration
date. These premiums are typically
approximate to their Black-Scholes expected values and dependent upon historical
volatility. The Black-Scholes equation
itself is conceptually identical to a neural valuation model derived from
neuroimaging data by Read Montague (Neuron, 2002). These valuation equations are rough approximations,
and our continuing neuroimaging research will examine the influence of expectations
and news on risk assessment and discrepancies beween implied and actual
options valuations.
Another
valuation phenomenon is the lofty valuations given internet stock IPOs without
profits during the internet bubble. Companies
without profits saw their valuations rise more, post-IPO, than profitable
companies. It is now known that our
emotions will strongly influence assessments of those stocks about which we
have less information (McDonald and Dremen, 2001; Slovic et al, 2002).
PATTERN DISCOVERY
One
area of the brain, the anterior cingulate, finds patterns in data. A sequence of accurate predictors being only
two in length can trigger the anterior cingulate to extrapolate that a pattern
has been formed. If corporate earnings
are above or below expectations for at least two quarters, then inappropriate
extrapolations will often be made. Several
money management firms take advantage of the delayed return to realistic valuation
after an extrapolated pattern is broken.
MAGNITUDE OF REWARD
The
magnitude of a potential reward activates the brain proportionally to its
size. This increased activation indicates
that the person feels both more positive and more aroused by the potential
reward. Investors who anticipate a
large reward from an investment will feel happier and more aroused by it.
One danger is that as an investment rises, they may start to check
the investment’s progress more frequently.
For most investors, frequent performance feedback leads to lower overall
returns (Odean, 2001). Over-arousal
leads to over-trading, and positive feelings contribute to ignoring potential
risks.
PROBABILITY OF REWARD
The
probability of a reward occurring has an interesting effect on the brain. Rewards that occur with 50% probability are
more exciting than those that will occur with a 25% or 75% chance. Rewards of 0% or 100% probability are the least
exciting of all. Humans are most excited
to pursue payoffs of 50/50 certainty according to monkey research performed
by Fiorillo et al (2003). The Market Wizard Jimmy Rogers, when describing
his investment style in Market Wizards, said (to paraphrase): "I
just wait ‘til I see the money sitting there, then I walk over and pick it
up.” This statement makes investing
sound easy, but it neglects the fact that we are physically bored by certainty
– perhaps too bored to push up from our chairs. Relatively easy profits may be available, but they aren’t as exciting
or motivating to investors as the pursuit of risky bets, and that may be why
they persist
SYNTHESIS
A
synthesis of the magnitude and probability effects can be performed. It is now clear that the magnitude effect dominates
the probability effect for high-value predicted rewards. This synthesis explains lottery behavior: larger potential rewards are more exciting,
and this excitement dominates the contrary effect of their low probability.
For example, the low probability of payoff from internet stock investments
was irrelevant to investors if they imagined that just one of these investments
would be spectacularly profitable.
DISCUSSION
There
is currently a role for neuroimaging. Currently
our descriptions of brain activity allow new ways of understanding ourselves
in terms of very basic emotional and motivational processes. Demystifying investing and market behavior
is only one area to which these findings are relevant. Fortunately for investors, most experiments
into the reward system utilize money as the prototypical reward. No legal substance, other than money, is found
rewarding by all people. That’s one
idea investors can understand.
It
is the emotional balancing act between temptation of profit and fear of loss
that makes investing a dangerous game for many people. In conditions of uncertainty, we often desire
to give control to someone else, so we do not feel accountable for any mistakes
made. This is perhaps why so many people invest in market-underperforming
managed mutual funds (with high annual fees) rather than investing in no-load
index funds (the desire to yield control, and accountability, to someone else). It may also be why many asset managers prefer
managing others’ money rather than their own.
It is very stressful to earn money directly for oneself - the brain’s
reward system can be thrown into overdrive.
Our
work so far provides a basic understanding of valuation, reward processing,
and financial disappointment. The greatest value lies within an understanding
of what factors lead to dynamic shifts in these processes. The real value of our work for economists,
financiers, investors, and others lies in forecasting what and when new information
will lead to reversals of previous expectations, assumptions, and valuations.
This “market timing” work is only just beginning.