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.
I seem to remember an Alan Alda Scientific American show about exactly how absurd the idea of day trading is. Apparently, nobody can get it right (make money in the long run), no matter how trained or credentialed they might be. And none of those fancy predictive algorithms could actually predict better than chance. I'm not sure how true that is, but it sounded about right to me!
In this comfortable modern world we live in, I think most stress boils down to wanting control. We'd like to be able to manipulate our environment - get someone to praise hard work, fix some worldly problem that's completely out our hands, change a partner to some exact expectation, etc. The anxiety shows up when we learn that we don't have control over most things. The lack of control can even include our own selves: why aren't I happy today, why can't I be more XYZ, why on earth did I say that out loud, etc. Maturity is all about learning to accept those situations where the outcome isn't exactly what you thought would happen.
Money is such a touchy subject... it turns everybody into little children, squabling or bitter about small misunderstandings or differences of opinion and unable to see someone else's point of view. It can be worse than religion or politics that way. Maybe money's just a really good example of a place where we think we have control over something but we don't.
(The other important feature about money is that it is very isolating. It's not like I can join a "the way to financial freedom is to drive a $300 toyota camry into the ground" club, or, if there is a club - like the "ought to own an iphone to be cool" group - there's also exclusion and rejection)
My families house burned down when I was 14. I learned right there and then what is required to live a life. And material possessions was not one of them. Most people don't take the steps to properly plan or prepare. And people are unable to put things in proper prospective. My portfolio took a hit this week. But it took less of a hit because I made adjustments over the last few months in preparation for a economic slowdown. And I didn't think twice about it. But seeing other people literally panic because their 401(k) is now at the same level as it was last year at this time is sad sight to witness. But I also have little sympathy for em.
So I am in no way regretting a single investment I have.
A very intersting study.
Another way (an not at all mutually exclusive) is to look at this in terms of people only having a limited set of "inate" models, which leads them to occasionally try to smash square pegs into round holes when making intiutive sense of events. In this case (a naive investor investing in a bubble or crash), it would seem that the problem is a linear extrapolation of a process that has a feedback loop. Not sure how much this would extrapolate to professional investors, who are generally at least intellectually aware of what's going on due to changing P/E ratios. It'd be interesting if they actually did some of these experiments using fund manangers. (I also wish they had clarified the backgrounds of the subjects - 54 healthy subjects ages 19-54 isn't a lot to go on - and in cases like this background knowledge about financial markets would be relevant.)
It is an interesting contrast to the gambler's fallacy, which would correspond to a bad assumption that a random process is cyclical. In this case, the experience is interpreted in the opposite manner - "I chose red the last 3 times and I lost, so I should keep playing red since it's 'due'", rather than "I chose red the last 3 times and I lost, so I should chose black going forward."
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