A study in the Proceedings of the National Academy of Sciences published today may change the way we think about market bubbles and crashes by illuminating how our brains function when we think about them.
Researchers from the California Institute of Technology, Virginia Tech, and University College London carried out a study in 2012 in which experimental markets involving 11 to 23 subjects began with each subject receiving 100 units of experimental currency as a risk-free asset, and six units of an asset deemed risky. As the subjects bought and sold their risky assets, price bubbles usually formed around the 30th period (subjects could buy or sell one risky asset unit each period). As the subjects participated through the 50 periods that made up each experimental market, several subjects at a time were scanned using functional MRI. (The full report can be found here.) The results should appeal to former Federal Reserve Chairman Ben Bernanke, who famously suggested that to understand market crashes, “progress will require careful empirical research with attention to psychological as well as economic factors.”
Among the subjects scanned using fMRI, the researchers found that two kinds of brain activity were critical to understanding how bubbles formed and how – and when – they popped. The subjects who ultimately did the worst had higher levels of statistically significant neural activity in their nucleus accumbens (NAcc). It has been demonstrated in numerous studies that the NAcc plays a large part in mental positive reinforcement. The study concluded, therefore, that “the lowest-earning subjects express a stronger tendency to buy as a function of measured NAcc activity,” and that “NAcc activity aggregated within a market predicts future price changes and crashes.” In other words, those with the lowest returns were too excited by the thrill of winning to realize that they were losing before it was too late.
However, what was really predicting the crashes turned out to be a signal in the brains of those who ultimately came out ahead. This signal is in the anterior insular cortex, the part of the brain “active during bodily discomfort and unpleasant emotional states, such as pain, anxiety, and disgust.” When this signal would activate in the subjects, it preceded the price peak, and those who experienced it had a higher propensity to sell. The study concluded that it “may represent a neural early warning signal.”
By one name, this signal could be called a self-fulfilling prophecy: when the most successful investors sensed that something was off, perhaps attributing their discomfort to the price having inflated too much (that same part of the brain is activated by financial risk), they sold, and their sales always preceded the crash – but because the experimental markets were so small and the variables so controlled, the subjects’ discomfort and subsequent decisions to sell may have precipitated the crashes. In the larger context of the stock market, where the uncanny ability to sense that a crash is coming despite the distraction of countless variables is literally invaluable, this sixth sense that the lowest earners lacked could be called by another name: a bull**** detector.