The Frontal Cortex

The Neuroscience of Market Bubbles

Given the recent bursting of the housing bubble (let’s hope, at least, that we’ve hit rock bottom), Kevin Drum raises an interesting issue:

Bubbles come along with some frequency these days, always with some shiny new reason for bankers to become irrationally exhuberant. Just in the last couple of decades we’ve seen bubbles in S&Ls (safe as houses!), South American countries (sovereign states never default!), junk bonds (greed is good!), dotcoms (eyeball, not profits!), and now housing (safe as houses!). Every time, it turns out that there’s nothing new at all. The economy has not been fundamentally changed, risk and reward are still roughly proportional, profit still drives stock prices, and supply and demand still function about the same way they always have.

And there’s one other thing that always stays the same: the object of the particular bubble that’s just burst comes under increasing scrutiny, but nothing is ever done to try to address the underlying issues in the finance industry which, left to its own devices, will simply move along and create a new bubble somewhere else in a few years.

Why are bubbles so common? I think part of the answer can be found, not surprisingly, in the quirky calculations of the human brain. Look, for example, at this experiment, published in May in PNAS. A group of researchers led by Read Montague had people play an investment game while their brain was imaged in an fMRI machine. At the beginning of the game, each subject was given $100 and some basic information about the “current” state of the stock market. Each person then chose how much money to invest in the market. After making up their mind, the players nervously watched as their investments either rose or fell in value. The game went on like this for twenty rounds.

The stock markets used during the experiment weren’t random simulations. Rather, the scientists used data from famous historical markets, most of which were classic financial bubbles. Subjects in the experiment “played” the Dow of the late 1920’s, the Nasdaq of 1998, the Nikkei of 1986 and the S&P 500 of 1987. This let the scientists monitor the neural responses of investors during real-life booms and the inevitable crashes.

After just a few rounds, the scientists started to pick up a strong neural signal that seemed to be driving many of the investment decisions. Take, for example, this experimental situation. A player decides to wager 20 percent of his total portfolio in the market, which is a rather conservative bet. Then, he watches as the market rises dramatically in value. (Perhaps he’s playing the Nasdaq in the late 90’s.) At this point, the investor experiences a strong feeling of regret. When he contemplates the counterfactual – what if I’d invested all of my money in the market – he comes to the correct conclusion that he would have made much more money. What’s interesting about this experiment is that the scientists were able to actually see this regret signal in the brain, which was manifested as a swell of activity in the ventral caudate, an area rich in dopamine neurons.

What’s the purpose of all this “fictive learning”? Our mind is busy figuring out the difference between the return “that could have been” and the actual return. This calculation strongly influences our future decisions. The more we regret a decision, the more likely we are to do something different the next time around. As a result, investors in the experiment naturally adapted their investments to the ebb and flow of the market. When the market was going up, this meant that their automatic counterfactuals were persuading them to invest larger and larger amounts in the market. After all, if they’d made a certain amount of money by investing 50 percent of their portfolio in the market, imagine how much money the would have made if they’d invested everything?

Obviously, the ability to learn from counterfactuals is a crucial cognitive skill. It allows us to learn not just from experience, but from hypothetical scenarios. But I think this system goes bezerk during bubbles. The market keeps on going up, and so we are led to make larger and larger investments in the boom. (To not invest everything means that we are constantly regretting the gains we missed.) In this sense, every bubble is partly a symptom of the counterfactuals in the ventral caudate getting carried away.* We are so worried about the gains we haven’t realized that we forget to think about the possibility of a loss. But, of course, every bubble bursts.

*I’d also emphasize the role of financial news in making bubbles more common and exaggerated. Because we are constantly being inundated with breathless reports about various booms – see, for example, CNBC circa 1998 – we experience much more regret when we don’t invest in some shady dot-com company, or in Florida real estate, or in whatever the next boom will be. (My hope is that the next boom is in green technology, so at least we’ll get some valuable technology from all of our squandered investments.)

Comments

  1. #1 Electric Dragon
    August 17, 2007

    Previous bubbles have often provided us with valuable technology (or rather infrastructure). Think of the railways of the 19th C. Or the large amounts of optic fibre laid at the height of the tech boom – that only now is being used to its capacity (or maybe not – look up dark fibre). Or the offices in London’s Docklands – they stood empty for years and bankrupted their builders, but are now the engine of London’s growth as a financial hub. The key is that the best returns often don’t come till later – and while the boom participants end up out of pocket, destitute or in prison for fraud, the people who pick up the pieces are the ones who can profit.

    Have any similar experiments actually look at professional market traders? I would expect that they are more used to dealing with losses than the average person. Also, there are many participants in the market – such as pension funds – that have to take innately low-risk/long-term positions.

    Perhaps bubbles only happen when a large number of inexperienced traders who haven’t learnt from previous bubbles get involved. In the dot com bubble I kept reading stories about people who had given up being a truck driver in Nebraska or a rivet welder in Kansas to be an internet day trader. That was a recipe for disaster – it becomes like a pyramid scheme in that people are only looking for short term capital growth (instead of long term dividend yield) and they can only get that from selling the stock on to a “greater fool” – of which there is a finite number. Once the number of fools runs out, the market will collapse. As the saying goes, when your cab driver starts giving you stock tips, that’s the time to exit the market.

  2. #2 harold
    August 17, 2007

    Predicting exactly when a bubble is happening, how long it will last, and so on, is very hard.

    Predicting that bubbles will occur is very easy.

    My hypothesis is that modern finance sometimes sets up situations where highly selected “biorational” behaviors are punished.

    In the jungle, when you see one of your fellow primates duck, you should duck, too. When everybody seems to be finding tasty termites in a certain tree, you should jump on the bandwagon until the termites are gone. Instinctively following the crowd is the right decision for social animals in many, many life and death circumstances.

    When dealing with the abstraction of financial instruments, though, the strong instinct to do what others do means that reactions to real or rumored economic information are frequently exaggerated.

    Hence adages like “when everyone’s cryin’, you should be buyin’ “. However, in practice, “anti-herd” strategies can be as difficult as any other type of “market timing”. Just because you think there’s a bubble doesn’t mean you can guess how big it will get, when it will end, how far down the crash will go, etc.

  3. #3 Quisp
    August 18, 2007

    the problem with hoping for a green technology bubble is that we want to avoid what happened, for example, to England in the last part of the 19th century. Then, the speculative new market that was making everyone rich was the new technology ELECTRICITY. Of course, everyone went nuts investing in the new tech, and when the bubble burst and everyone lost their shirts, it took England several decades to catch up to the rest of the modern world in terms of electricity. Thus, all those gaslights in England long after electricity was the norm here. The bubble and the ensuing crash made that technology a “bad investment” in the minds of the folks who got burned the first time around.

  4. #4 Chris Gower-Rees
    August 21, 2007

    My chief concern is the misuse of knowledge about the neuroscience of market bubbles, and indeed neuroscience overall, by organizations who use it to manipulate and subjugate. This includes all sorts of profit making organizations as well as governments and other entities who have no interest in serving humanity, only their “cause”.

  5. #5 Martyn Strong
    March 2, 2009

    Capital markets are unstable. In the past there was no way to make them stable. But today we have computer power that can be used to make them stable. By using the greater computer power of today we can have a much higher turn over of capital in the capital market. This higher turnover will make the market harder to game or control and the market will no longer have the unstable run ups or declines. Who can change or control the market when say 20% of the capital is trading each day? So now that we have the compute power to provide for all these transactions that will smooth out the market how do we force people to turn over at a rate of 20% a day? Easy, put a cap gains tax of 0% (zero) on all gains of 7 days or less and put a cap gains tax of 90% of all gains of more than 7 days. The likes of Yahoo, Micosoft and/or Sun Micro Systems will give us the systems that will provide automated software agents to support turning over one’s investments every 7 days (based on the specs you give the agent). A system like this will make the financial markets work as smoothly as the local fruit market.

The site is currently under maintenance and will be back shortly. New comments have been disabled during this time, please check back soon.