I’m sorry about the lack of posts: I’ve been traveling. (I’m currently in the surprisingly chilly and wet Los Angeles area.) Given the turbulence on Wall Street recently, I thought I’d repost something I wrote last year on the neuroscience of regret and financial decisions. The experiment, designed by the lab of Read Montague, was simple: each subject was given $100 and some basic information about the “current” state of the stock market. The “investors” 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 booms and busts. 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 and panics. The market keeps on going up (or down), and so we are led to make larger and larger investments in the boomm or to keep on selling when things start to look bad. (To not invest everything means that we are constantly regretting the gains we missed. And to not sell everything means that we are constantly regretting the losses we are taking.) In this sense, every bubble and panic 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. Or we are so worried about getting stuck with plummeting stocks that we keep on selling and selling, even if the fundamentals don’t warrant such a decline. I’m just relieved that, at least for now, the market seems to have gotten control of its caudate.