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What separates the wolves from the sheep in the stock market?

"Be fearful when others are greedy and be greedy only when others are fearful," said Warren Buffet, arguably the most astute contemporary investor in the world. Research by Caltech and Virginia Tech backs this sound advice, after delving deep into the investor mind and framework by analyzing stock market behavior at the neurolevel.

Tibi Puiu
May 11, 2016 @ 1:00 pm

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“Be fearful when others are greedy and be greedy only when others are fearful,” said Warren Buffet, arguably the most astute contemporary investor in the world. Research by Caltech and Virginia Tech backs this sound advice, after delving deep into the investor mind and framework by analyzing stock market behavior at the neurolevel. Apparently, some parts of the brains of wise traders light up differently when they receive a signal that it’s time to maybe back down and sell, even though the market is rising and far from its peak.

warren-buffet

Known as “the Oracle of Omaha”, Buffett is Chairman of Berkshire Hathaway and arguably the greatest investor of all time. His wealth fluctuates with the performance of the market. For instance, in 2008 he was the richest man in the world; today he’s classed at #3. Credit: Wikimedia Commons

Buy low, sell high

The hallmark of the work is the discovery of two key brain mechanisms that describe distinct types of activity in the brains of participants. One such type of brain activity was observed in a tiny fraction of the study participants. It made them nervous, twitchy and prompted them to sell their stocks even though the prices were on the rise. The other mechanism was far more common and was shared by most participants, prompting them to behave greedily and buy shares aggressively  during the bubble and sometimes even after it collapsed.

The lucky few who received the early warning signal got out of the market early and earned the most money. The others displayed what former Federal Reserve chairman Alan Greenspan called “irrational exuberance” and lost their proverbial shirts.

The researchers organized 16 trading sessions, each attended by 20 participants or so. Each participant was instructed how a screen trading market worked and was given 100 units of an experimental currency and six shares of a risky asset. Then, over the course of 50 trading periods, the traders indicated by pressing keyboard buttons whether they wanted to buy, sell, or hold shares at various prices.

The fundamental price of the risky asset was set by the researchers at 14 credits, but what’s interesting is that in many of the sessions the traded price of the asset rose far more than this. In fact, in some situations, the trading price was five times higher. Of course, this gave rise to bubble markets that eventually crashed.

“The first thing we saw was that even in an environment where you don’t have squawking heads and all kinds of other information being fed to people, you can get bubbles just through pricing dynamics that occur naturally,” says Camerer. This finding is at odds with what some economists have held—that bubbles are rare or are caused by misinformation or hype.

Throughout the experiment, the participants had their brains scanned by a functional magnetic resonance imaging (fMRI) machine. In fMRI, blood flow is monitored and used as a proxy for brain activation. If a brain region shows a relatively high level of blood oxygenation during a task, that region is thought to be particularly active.

Based on their performance over 50 trading periods, participants were divided into three main categories: the low, medium and high earners. People in the middle ground didn’t take many risks and as a result neither made nor lost money in the process. The traders who were on the low margin tended to be impulse buyers that traded on momentum. The high earners, on average, bought early and sold when the stocks were on the rise.

“The high-earning traders are the most interesting people to us,” Camerer says. “Emotionally, they have to do something really hard: sell into a rising market. We thought that something must be going on in their brains that gives them an early warning signal.”

Irrational investors are clouded by emotions

When the outcomes of the trading sessions were shared with the participants, fMRI scans revealed how a region called the nucleus accumbens (NAcc) lit up.

This region is associated with reward processing—it lights up when people are given expected rewards such as money or a paid off gamble, like in the trading business. A very interesting finding was that poor earners – those who’ve basically lost their shirts – were very sensitive to activity in the NAcc: when they experienced the most activity in the NAcc, they bought a lot of the risky asset.

“That is a correlation we can call irrational exuberance,” Camerer says. “Exuberance is the brain signal, and the irrational part is buying so many shares. The people who make the most money have low sensitivity to the same brain signal. Even though they’re having the same mental reaction, they’re not translating it into buying as aggressively.”

History is written by the victor, however. What makes the high earners better? The researchers hypothesize that a part of the brain called the insular cortex, or insula, is key.

Previous studies have linked the insula to financial uncertainty and risk aversion. It is also known to reflect negative emotions associated with bodily sensations such as being shocked or smelling something disgusting, or even with feelings of social discomfort like those that come with being treated unfairly or being excluded.

“The scans showed that the insula activity shortly before the traders switched from buying to selling. And again, Camerer notes, “The prices were still going up at that time, so they couldn’t be making pessimistic predictions just based on the recent price trend. We think this is a real warning signal.”

Meanwhile, in the low earners, insula activity actually decreased, perhaps allowing their irrational exuberance to continue unchecked.

“Individual human brains are indeed powerful alone, but in groups we know they can build bridges, spacecraft, microscopes, and even economic systems,” says Read Montague, director of the Human Neuroimaging Laboratory at the Virginia Tech Carilion Research Institute and one of the paper’s senior authors. “This is one of the next frontiers in neuroscience—understanding the social mind.”

The findings of the paper were reported in the Proceedings of the National Academy of Sciences.

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