Next time you make a boneheaded investing move – you hold on to losers for too long, or sell winners too early – blame it on your insular cortex and nucleus accumbens. These regions of the brain have a lot to answer for.
At least, that’s one of the research findings of Colin Camerer, a professor and behavioural economist at the California Institute of Technology in Pasadena, Calif. He’s been studying what experts call the “disposition effect” to determine why people are so bad at buying and selling investments at the optimal times.
While behavioural economists might look at social factors that go into the decisions we make, Dr. Camerer is exploring the brain mechanisms that cause biases and emotions in the first place. Neurofinance is an emerging area of research that puts functional magnetic resonance imaging (fMRI) and other scanning techniques to work examining what happens in the brain when we make decisions about money.
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In one of Dr. Camerer’s studies, he slid a few dozen Caltech undergraduate students into an MRI machine, handed them a small button box and showed them financial information. Based on what they saw, students had to decide whether they wanted to buy, sell or hold fake stocks as they gained and lost in value.
In the end, even these math-and-science whiz kids got it all wrong: Most sold their winners and held on to losers.
“When people have bought a stock and it goes down relative to where they first bought it, they hate to sell it,” he explains.
The trick is to connect the “hate” with the brain’s response by observing which regions light up. For instance, the aforementioned nucleus accumbens is linked to the reward circuit and thought to be directly involved in addictive behaviours such as drinking, drugs and gambling. People who lost big in his studies tended to have more activity in this region of the brain.
The participants who sell the winners and hang onto the losers have the strongest brain signals, he confirms.
Other scientists are doing research in neurofinance, of course. They are looking into how activity in the orbitofrontal cortex is linked to feelings of regret – an emotion well known to investors. Others are observing how the brain reacts to the anticipation of gains and losses and how an active insular cortex reduces rash behaviour.
A variety of other industries and interests are looking into neurofinance as well. “There’s a certain amount of faddish marketing out there. Like, neuro-blank is hot,” Dr. Camerer says, indicating fields such as neuro-ethics, neuro-law and neuro-marketing.
Steph Sharp, a negotiator with Ferax Consulting in Vancouver who has helped construct big corporate deals, says her firm uses teachings from neurofinance to inform its strategies. Rational decision-making, for instance, doesn’t work well and goes against how our brains perform. Success actually comes from going with the gut, she says.
Ms. Sharp says she’s not surprised at the level of interest in neurofinance. “People in the investing arena who have billions of dollars at stake want to know when investment decisions go wrong and why they are going wrong,” she says.
But can knowing what’s happening in the brain give us information we can act on? If we know that an area lights up, what good does that do? Dr. Camerer admits it’s a fair question and one he often discusses with his PhD students.
Knowing what’s happening in the brain can lead to causal experiments, for instance. If you are aware that a release of the neurotransmitter dopamine leads to erratic behaviour or risky trading, might there be a way to disrupt that release?
Dr. Camerer points out that people who have developed lesions in a certain part of the ventromedial prefrontal cortex, found behind the eyebrows, may not exhibit the disposition effect. It’s just an educated hunch, he says, but it could mean they would be better traders not bothered by misleading brain signals.
Not that investors should be lining up for a procedure that would alter their brain. “The problem is, it might help them trade, but then they’d have trouble deciding where to go for lunch,” he says. “That region is used to doing a lot of mental evaluation and decision-making.”
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The science behind neurofinance is exciting but has its limitations, at least for now, says Ruo Tan, president of Segal Rogerscasey Canada, an institutional investment consulting company in Toronto. Decision-making is complicated and depends on too many factors, not just those inside investors’ heads but in terms of world events and how they react to them.
“I think that [the science] is really positive and groundbreaking,” he says. “But as an investment advisor, you really need to look at a client situation individually. No two clients are identical.”