This Is Your Brain on a Financial Bubble

At this point, listening to politicians and pundits place blame on each other for the last half-decade of financial ruin has become sickening. What if there was more to the problem than just policy though? New neuroscience research is being published in the next issue of Neuron, and might take blame from the trading floor and pin it on traders' brains.

It's been five years since the collapse of Lehman Brothers, that iconic moment in which it looked more candid than ever that the finance industry—through predatory lending and bubble-bursting—had us headed for the tubes. In considering the brain activity of Wall Street traders, researchers looked at processes supporting the financial decisions that play into forming commodity and asset-based bubbles.

At the California Institute of Technology, student volunteer behaviors were studied as they traded in a fantasy style market. Participant brains were mapped using functional Magnetic Resonance Imaging (fMRI), which scans blood flow in the brain as an indication of activity.

By watching traders form bubbles in a make-believe market, a strong correlation was found between separate areas of the brain responsible for a) processing value judgments, and b) predicting the behavior of others by inferring their intentions. Financial 'bubble' formation, when trading and asset prices rush beyond the asset's intrinsic value, was connected to increased activity in the area that performs value judgments. Traders more likely to lose their money to a bubble exhibited a spike of activity in that area of the brain. Benedetto De Martino, a researcher at Royal Holloway University of London explained:

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… 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 team found that poor decisions arose whenever participants saw an increased disparity between an asset's worth and the rate of transactions for that asset. A deviation that trends upward and away from that established price attracts a swarm of trading activity and results in a sort of vicious cycle of shitty decision making.

A co-author of the study Peter Bossaerts, from the University of Utah, candidly explained the rationale behind the group behavior. "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."

Even though the research can't necessarily predict exactly how and where bubbles begin, hopefully such research will aid the design of interventionist methods to avert future bubble bursts. And it's easy to see how policy can be shaped in the future, if lawmakers keep in mind the swarming behavior of people who are all, as we feared, are prone to flights of fancy from data-based speculation.

@danstuckey