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Drivers of financial bubble-and-crash process may lie in the mind

Sept. 19, 2013
Courtesy of the Wellcome Trust
and World Science staff

Mar­ket bub­bles lead­ing to fi­nan­cial crashes may flow from in­stinc­tive mech­a­nisms in traders’ brains that lead them to try and pre­dict how oth­ers be­have, ac­cord­ing to a stu­dy.

Re­search­ers at the Cal­i­for­nia In­sti­tute of Tech­nol­o­gy com­bined ex­pert­ise in ex­pe­ri­men­tal fi­nance and neu­ro­sci­ence to ex­am­ine the brain ac­ti­vity and be­hav­ior of stu­dent vol­un­teers as they traded shares with­in a staged fi­nan­cial mar­ket.

A market bub­ble de­vel­ops when trad­ing of some as­set pushes it to prices con­sid­erably above its in­trin­sic val­ue. A price crash usu­ally fol­lows. The boom and bust of the “dot com” sec­tor and the re­cent crash in hous­ing mar­kets are re­cent ex­am­ples that re­sulted in bil­lions of dol­lars in losses. 

The re­search­ers used func­tion­al Mag­net­ic Res­o­nance Im­ag­ing, a tech­nique to meas­ure the flow of blood in the brain as an in­dica­t­ion of ac­ti­vity, to map par­ti­ci­pants’ brain ac­ti­vity as they traded with­in the ex­pe­ri­men­tal mar­ket. They found that bub­ble forma­t­ion was linked to in­creased ac­ti­vity in an ar­ea of the brain that pro­cesses val­ue judg­ments. Peo­ple with great­er ac­ti­vity in this ar­ea were more likely to ride the bub­ble and lose mon­ey.

In bub­ble mar­kets, the re­search­ers al­so found a strong link be­tween ac­ti­vity in the val­ue-processing brain ar­ea, and an­oth­er that com­putes so­cial sig­nals to in­fer oth­er peo­ple’s in­ten­tions and pre­dict their be­hav­ior.

“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,” said Be­ne­det­to De Mar­tino, a re­search­er at Roy­al Hol­loway Uni­vers­ity of Lon­don who led the study while at the Cal­i­for­nia In­sti­tute of Tech­nol­o­gy.

“These brain pro­cesses have evolved to help us get along bet­ter in so­cial situa­t­ions and are usu­ally ad­van­ta­geous. But we’ve shown that when we use them with­in a com­plex mod­ern sys­tem, like fi­nan­cial mar­kets, they can re­sult in un­pro­duc­tive be­hav­iors that drive a cy­cle of boom and bust.”

The team found that when par­ti­ci­pants no­ticed dis­par­ity be­tween how much they per­ceived an as­set to be worth and the rate of trans­ac­tions for that as­set, they be­gan mak­ing poor busi­ness de­ci­sions and bub­bles started to form.

“It’s group il­lu­sion. 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,” said Pe­ter Bos­saerts of the Uni­vers­ity of Utah, a co-author of the stu­dy. The find­ings may not help to pre­dict a bub­ble, but could help to de­sign bet­ter in­ter­ven­tions to avoid their forma­t­ion, the in­ves­ti­ga­tors said.

The study was pub­lished on­line Sept. 18 in the jour­nal Neu­ron.


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Market bubbles leading to financial crashes may flow from instinctive mechanisms in traders’ brains that lead them to try and predict how others behave, according to a study. Researchers at the California Institute of Technology combined expertise in experimental finance and neuroscience to examine the brain activity and behaviour of student volunteers as they traded shares within a staged financial market. A financial “bubble” develops when active trading of a commodity or asset reaches prices that are considerably higher than its intrinsic value. A market crash usually follows. The boom and bust of the “dot com” sector and the recent crash in housing markets are recent examples that resulted in billions of dollars in losses. The researchers used functional Magnetic Resonance Imaging, a technique to measure the flow of blood in the brain as an indication of activity, to map participants’ brain activity as they traded within the experimental market. They found that bubble formation was linked to increased activity in an area of the brain that processes value judgments. People with greater activity in this area were more likely to ride the bubble and lose money. In bubble markets, the researchers also found a strong link between activity in the value-processing brain area, and another that computes social signals to infer other people’s intentions and predict their behaviour. “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,” said Benedetto De Martino, a researcher at Royal Holloway University of London who led the study while at the California Institute of Technology. “These brain processes have evolved to help us get along better in social situations and are usually advantageous. 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 when participants noticed disparity between how much they perceived an asset to be worth and the rate of transactions for that asset, they began making poor business decisions and bubbles started to form in the market. “It’s group illusion. 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,” said Peter Bossaerts of the University of Utah, a co-author of the study. The findings may not help to predict the onset of a bubble, but could help to design better interventions to avoid their formation, the investigators said. The study was published online Sept. 18 in the journal Neuron. may be all in the mind