Understanding Foolishness: Neuroeconomics and Behavioral Finance

A brief overview of the fascinating field of neuroeconomics.

As much as we love finance, we have to recognize that there is a certain proportion of the CFA material that is a tiny bit dry. It would probably be an euphemism to say that there is a boredom factor at work when studying some of the material. Sometimes, digging deeper into a topic can make it more interesting and bring a new perspective to your study of that subject. To me, one topic of interest included in the CFA curriculum is behavioral finance and market efficiency.

We decided at Financial Analyst Warrior to dig deeper into Neuroeconomics which we found was an fascinating area which is related to behavioral finance (but mostly outside the scope of the CFA). We will try once in a while to bring you more in depth information in a specific area of finance included in the CFA or related to the course of study. Significant work was invested in this small research (although we dont really mind as much since we have nerdish tendencies) we appreciate the feedback!

Neurology and Economics: Bridging the Gap

Traditionally, the fields of finance and economics made simplifying assumptions to explain the behavior of economic agents and formulate financial theories. They describe people’s behaviors as rational, that is, utility maximizing. In the last few decades, the field of psychology offered a new point of view on people’s financial behaviors and identified biases displayed by them when performing economic or financial decisions. This was the advent of behavioral finance. In recent years, neuroscience attempted to shed more light on the flaws identified in behavioral finance (Economist, 2008). This report will provide an overview of the arguments supporting traditional financial theory and those from the proponents of neuroeconomics. Our opinion on the validity of this new field relative to traditional financial theory will then be outlined and discussed.

Traditional theories and The Homo Economicus

Modern investment theory and the fields of finance and economics use the idea of the rational economic man, coined “homo economicus” (Andrikopoulos, 2007). This term refers to a greatly simplified behavioral model describing individuals as perfectly self-interested, rational and having free access to perfect information (Andrikopoulos, 2007). Since actual human behavior was to complex to integrate it in mathematical models, it was oversimplified to fit models such as capital asset pricing models, arbitrage pricing theory and efficient market theory. Academics attempted to explain anomalies observed in the market by creating more complete and more complex mathematical models (Shiller, 2002).

Behavioral finance and neuroeconomics

In the 1990s, academic focus shifted to behavioral finance and toward developing models that considered human psychology as it relates to financial markets (Shiller, 2002). Behavioral finance attempts to explain and predict market behavior from various psychological biases (Andrikopoulos, 2007). More realistic models of human decision making were developed that recognize that contrary to the homo economicus, people often did things that were not in their self-interest (The Economist, 2008). An example of this would be an investor who refuses to liquidate a stock that has lost its value and that has meager chances of recovering to higher levels. The investor would be clearly better off selling the loser and redeploying the capital toward another stock that has brighter prospects. However, the loss aversion bias will prevent many investors to implement this rational decision.
[quote align=”center” color=”#999999″]‘‘Human behavior, in general, and presumably, therefore, also in the
market place, is not under the constant and detailed guidance of careful
and accurate hedonic calculations, but is the product of an unstable and
unrational complex of reflex actions, impulses, instincts, habits, customs,
fashions and hysteria.’’
(Viner, 1925)[/quote]

More recently, a new light has been shed on biases discovered by behavioral finance. It came from the study of brain activity as individuals perform financial decisions. What was seen previously as a “black box” by economists is now being opened and studied: the human brain. Neuroeconomics attempts to bridge the gap between neuroscience and economics (Cramer, 2004). The technique used to delve into brain activity while financial decisions are made is through a magnetic resonance imaging (MRI). Below is a picture showing the results of a MRI:

MRI Result

MRI Result

This technique enables researchers to identify which areas of the brain are solicited when certain decisions are made. One example of the success of MRI in explaining irrational behavior is the “ultimatum game” where one player proposes a division of a sum of money between himself and another player. The other player must accept or reject the offer and if he rejects, neither gets money. Economic theory would suggest that the second player would accept any amount since it is better to have some amount than nothing. However, the second player routinely turned down low offers, perhaps to punish the first player for proposing an unfair split (Economist, 2008). Neuroeconomists have found that the rejection of a low offer is associated with activity in the dorsal stratium, a part of the brain involved with reward and punishment decisions (Economist, 2008). The loss aversion bias mentioned previously has also been investigated through MRI. Craig R. Fox and Russell A. Poldrack at the University of California showed that potential for gains coincide with increased activity in the mesolimbic and mesocortical dopamine systems and as potential for losses increased, a decrease activity in the same areas of the brain was observed. Dopamine is a neurotransmitter substance associated with motivation and reward (Shermer, 2007). The Fox and Poldrack study shows how differences in loss aversion is predicted by how much more the brain is turned off by losses than turned on by gains. Another study by Smith, Dickhaut, McCabe and Pardo (2002) also shows violations of economic assumptions. Participants and their study proved to be risk averse in gains and risk seeking in loss (Smith, 2002). According to them, the demonstration of a relationship between brain activity and economic choices proves the feasibility of neuroeconomic decision science (Smith, 2002). Yet another bias has been demonstrated through neuroeconomics. This bias, again demonstrated through a MRI, states that people prefer sooner and smaller rewards than larger rewards later (Takahashi, 2009). In addition, Knutson claimed that neural activation prior to financial decisions contributes to rational and irrational choices (2003). He found that distinct mechanisms are solicited for taking and avoiding risks (Knutson, 2003). Neuroeconomics even attempted to explain the recent crisis. Traditional finance theory difficultly explains the boom and busts cycles since it signals market’s inefficiency at pricing assets. The behavioral bias of money illusion is used by Gary Stix (2009) to explain the American housing bubble that preceded the recent economic crisis. Neuroeconomists has found that the ventromedial prefrontal cortex is associated by the money illusion bias (Stix, 2009). See below for a map of the brain areas.

Map of Brain Areas

Map of Brain Areas

Attacks on neuroeconomics: how useful is it really?

Despite these researches in the new field of neuroeconomics, many skeptics or proponents of traditional financial models offered arguments against neuroeconomics. The most widely cited among these is that of Faruk Gul and Wolfgang Pesendorfer (2005). They claimed that “the requirement that economic theory simultaneously account fir economic data and brain imaging data places an unreasonable burden on economic theories” (Gul, 2005). In other words, they do not see the need to reconcile the “gap” between the two sciences mentioned by pioneers of neuroeconomics such as Colin Cramer. In the end, what is relevant is the decisions people make, not the process by which they make those decisions (Gul, 2005). Besides, neuroeconomics can only identify activities in large section of the brains so far which offers limited insight (Economist, 2008). Even neuroeconomist Colin Cramer is pessimistic on the chances of this new field of offering useful insight (Economist, 2008). Nobel Prize winner in economics Daniel Kahneman is a supporter of neuroeconomist but recognizes that: “we are nowhere near the demise of traditional neoclassical economics” (Economist, 2008).

Irrationality vs. the need for a map

This is an overview of the claims from both proponents of neuroeconomics and behavioral economics and opponents of these relatively new sciences. We found that the neuroscience mostly serves to provide scientific evidence of behavioral traits already discovered by behavioral finance. Personally, given my relatively brief experience in the markets, believe that the Homo Economicus or rational man assumptions of traditional theories do not reflect accurately the actual financial decision making process made by individuals. Indeed, individuals are subject to irrational behavior when making economic choices, which will lead them to depart from choices predicted by most traditional economic models.
However, I believe that the fact that individual tend to make occasional irrational financial decision does not provide sufficient grounds for dismissing traditional neoclassical economics altogether. In other words, the behavioral discoveries and their neuroeconomic proofs do not invalidate financial models. For an investor, they represent interesting facts to be cognizant of but should not constitute the fulcrum of his analysis and decision making process. For instance, it is important that, as an investor or a trader, I be aware of the overconfidence bias. Nonetheless, my investment decisions will still be grounded in some rational investment model. Before selecting the stock that her analysis recommended, an investor may pause and ask herself if she is falling victim to some bias but this will likely have a negligible impact on the overall investment decision. Therefore, I agree with the existence of behavioral biases but doubt their usefulness in implementing financial decisions beyond additional awareness. Daniel Kahneman mentioned an analogy where the financial models although imperfect at describing accurately human behavior, serve as a map that gives market participant a “starting point” or guideline on their decision making (Rolnik, 2009).

One of Colin Camerer’s arguments for the contribution of neuroscience to economics is that it suggests that “economic choices considered differently in theory use the same brain circuitry” (Camerer, 2004). This may be true but it is difficult to see how economic formulation can change to integrate brain circuitry. More importantly perhaps, as mentioned by Gul and Pesendorfer (2005), is there a need to reconcile the two?

Although I believe that behavioral finance and neuroeconomics provide an insightful perspective on human decision making that is much more realistic than the assumption of rationality previously utilized in economic models, I do not believe that we can therefore write off these models as useless. The “traditional” economic and financial models are still relevant. In addition, according to the literature on the topic and as said by Kahneman, for the moment, neuroeconomics can achieve little more than to offer a richer definition of rationality…

This ended up being a longer post than I expected…I got carried away in the research… I hope you found it insightful and I included the bibliography below if you want further info.

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