What happens in the brain when choosing between two financial products? How about when the decision is perceived as ‘risky’? Can individual decisions be a predictor of how financial markets work?
These are the sorts of questions that have emerged from the developing relationship between neuroscience and finance… sometimes called “neurofinance” or “neuroeconomics”.
Understanding what happens in the brain when we make financial decisions is relatively new science but it is already proving to be interesting.
A new lab at the University of Miami’s School of Business has been set up to examine the relationship between the brain and finance.
Using electroencephalography (EEG) to measure electrical activity in the brain, and eye-tracking technology, it conducts experiments on finance students without the need for expensive fMRI technology.
One of the lead researchers explains what the neuroscience is trying to discover:
“Money doesn’t exist in nature. When a person says, ‘I’m going to save 20% of my paycheck to put into a retirement account,’ is that the same part of the brain a squirrel would use to put away nuts for the winter?”
“We’re trying to figure out what parts of the brain we use today to make financial decisions, what they were originally intended to do, and the consistency they have.”
The common assumption is that the decisions we make (regarding finances or anything else deemed as ‘important’) are purely rational decisions, taken without emotions interfering. In terms of finance there is a vast array of metrics used that allow us to make ‘informed’ decisions.
However, the findings from the lab back up previous neuroscience that shows that emotion plays a very important part in all decision-making.
The work of neuroscientist Antonio Damasio demonstrated that people with damage in the part of the brain where emotions are generated are also unable to make decisions – even simple ones like what clothes to wear.
In one of the experiments, students are given two institutions with exactly the same metrics, but with different names of people who run the funds. The latter information should not be a factor in the analysis of which fund to go with, but students consistently choose an American-sounding name over a foreign-sounding name. This is the effect of emotions in the decision-making process.
Can this help explain financial markets?
Neuroeconomics is a growing field that encompasses many fields including neuroscience, experimental and behavioural economics, cognitive and social psychology, theoretical biology, and mathematics.
One of the questions at the forefront of the field is whether understanding what happens in an individual’s brain when they make a financial decision may be extended to financial market behaviour.
The lead researcher at the University of Miami’s School of Business suggests the following:
“If you really think about the market, it’s a collection of people doing stuff. If you really want to understand group behavior, it makes sense to understand how they would make decisions at an individual level.”
A study from the California Institute of Technology sheds more light on this, suggesting that it is a biological impulse to predict how others behave – and that this helps to drive the type of fluctuations in the markets seen in ‘booms’ and ‘busts’. It was found that, rather than making dispassionate decisions based solely on explicit price and value data, traders were driven to predict how the market will change from the behaviour of other traders (in the belief that others in the market knew better than them).
Next time you are about to make a financial decision, stop and think: what is driving this decision? Is it really just analysis and numbers? Or are there emotions bubbling away in the background driving it?