Probing the investor's brain
May 1, 2011
Brian Knutson / Global Investor


Recent global market events (including the US housing bubble and its subsequent collapse) highlight gaps between economic theories and lay intuition. To economic theorists and laypeople, economic actors look completely different -- either rational and reflective or emotional and impulsive.

Traditional finance models imply that people invest based on the statistical qualities of risky options, for example, average past returns. These models further predict that individuals seek to maximize returns and minimize risk. But behavioral research suggests that people's actions do not always conform to these predictions (see companion piece by Camelia Kuhnen). The same person may both buy insurance and gamble, in other words, simultaneously opt for low returns and high risk.

Can research bridge the gap between theory and data? While reflective thought is hard enough to measure, emotional impulses are even more dynamic and fleeting. Technological advances, however, are giving researchers new insights into the interplay between passion and reason. In the past decade, improvements in neuroimaging techniques have allowed researchers to look deep into the brain on a second-to-second basis. Thus, investigators can isolate not only how the brain reacts to financial outcomes but also how it anticipates those outcomes.

Two findings have repeatedly emerged in our and others' research. First, when people anticipate financial returns (in the form of expected gains), deep brain regions (such as the nucleus accumbens, which rich in the neurotransmitter dopamine) show increased activity. These same regions activate when people anticipate positive sights, smells, or tastes, and their activity correlates with feeling both good and aroused (e.g., 'excited'). Second, when people anticipate financial risk (in the form of expected volatility), distinct but also ancient brain regions nearer to the skull (i.e., the anterior insula) show increased activity. These same regions activate when people anticipate negative sights, smells, tastes, or touch, and their activity appears to correlate with feeling both negative and aroused (e.g., 'anxious').

Activity in these deep brain regions also foreshadows upcoming choice. When people play an investment game, increased nucleus accumbens activation predicts greater risk seeking, while increased anterior insula activation predicts greater risk aversion. Further, incidental influences on activity in these regions may temporarily alter risk preferences. For instance, heterosexual males take more financial risks after seeing pictures of erotic couples than after seeing pictures of office supplies. Consistent with these findings, an "anticipatory affect" account posits that excitement accentuates the upside of risks, increasing their attractiveness. Conversely, anxiety accentuates the downside of risks, decreasing their appeal.

To some extent, the findings from this area of investigation, known as neurofinance, vindicate popular financial models by highlighting neural circuits that respond to return and risk. But they may also extend beyond traditional models. For instance, statistical properties like skew (i.e., large but unlikely outcomes) are not commonly considered, but may nonetheless influence choice. These findings might help explain the surprising attractiveness of gambles like the lottery.

Neurofinance is still a young field, but it has already produced coherent results with potential relevance to individual investors. Current findings, though, have generated more questions than answers. For instance, to what extent does neural activity related to emotion determine financial choice in the real world? At what point does rational reflection prevail? Most importantly, do these individual findings scale to the group level, and if so, when? Perhaps by shining a light on individual behavior, we can eventually better understand movements of the market.