Money and the Mind

1. Money and the Mind How Neuroscientists Are Cracking the Code of Investment Behavior Jason Zweig Money Magazine AIMR Annual Conference May 14, 2002

2. Money and the Mind Some Tentative Speculations on the Neuroscience of Investing Jason Zweig Money Magazine AIMR Annual Conference May 14, 2002

3. Money and the Mind • Most common answer: I don’t know • 2nd most common: We don’t know

4. Money and the Mind • Investment analysis is a purely rational process • Emotion leads to error • “Be fearful when others are greedy and greedy only when others are fearful” (W. Buffett)

5. Money and the Mind • Professionals have superior control over emotions • Professionals determine past trends more accurately • Professionals extrapolate future trends more reliably • Professionals less subject to overconfidence

6. Money and the Mind • If these things are true, then: • why does winning or losing the same amount of money feel so different? • why do analysts express high confidence in accuracy of their forecasts despite track record? • why does a stock that misses the consensus earnings forecast by $0.01 lose billions in seconds? • why do investors persist in finding patterns in random data (Internet “eyeballs,” earnings growth “trends,” technical “analysis”)?

7. Money and the Mind • Over some 60 million years of primate evolution, did the brain develop to: • avoid predators, identify predictable opportunities for foraging, seek simple patterns that maximize odds of survival? • calculate algorithms for foreign-currency arbitrage or option-adjusted spreads on collateralized mortgage obligations?

8. Research Rundown • Neuroscientists • Antonio Damasio, Antoine Bechara (Iowa) • Wolfram Schultz (Cambridge) • Read Montague (Baylor) • Jordan Grafman (NIH) • Raymond Dolan (University College, London) • Peter Shizgal (Concordia, Montreal) • Michael Gazzaniga (Dartmouth) • Angela Sirigu (Lyon) • Hans Breiter (Harvard) • Brian Knutson (Stanford)

9. Research Rundown • Economists • Jonathan Cohen (Princeton) • George Loewenstein (Carnegie Mellon) • Colin Camerer (CalTech) • Andrew Lo (MIT) • Kevin McCabe (George Mason) • John Dickhaut (Minnesota)

10. Research Rundown • Psychologists • Daniel Kahneman (Princeton) • Anthony Dickinson (Cambridge) • Dan Ariely (MIT) • Massimo Piattelli-Palmarini (Arizona) • Reid Hastie (Chicago) • William Gehring (Michigan)

11. The Nucleus Accumbens • part of ventral striatum (region of lower forebrain) implicated in probability calculations • helps explain pattern-seeking behavior in humans • representativeness: winning “streaks,” gambler’s fallacy • probably related to the “interpreter” module

12. Normally, what you see in each eye is analyzed by both sides of the brain (see arrows, panel 1). But if the brain's two hemispheres are surgically severed, that interchange breaks down. When the right side of the brain does the work (panel 2), people make better forecasts than when they use the left side (panel 3) -- suggesting that a function on the brain's left side tricks us into finding patterns even when they don't exist. Normally, what you see in each eye is analyzed by both sides of the brain (see arrows, panel 1). But if the brain's two hemispheres are split by a surgeon, this interchange breaks down. When the right side of the brain does the work (panel 2), people make better forecasts than when they use the left side (panel 3) -- suggesting that a function on the brain's left side tricks us into finding patterns even when they don't exist.

13. Unpredictable Do changes in predictability modulate brain response? Predictable Give predictable sequence of squirts followed by unpredictable sequence. Red = juice Blue = water Courtesy of P. Read Montague, Baylor School of Medicine

14. Changes in predictability of sequential stimuli modulate brain response in the ventral striatum. 8 n = 25 p < 0.001 T score 0 y = 16 mm Courtesy of P. Read Montague, Baylor School of Medicine

15. Left NAc Right NAc 0.8 p < 0.0005 * 0.6 Mean Brain Response (Unpredictable – Predictable) 0.4 0.2 0.0 Conservative Risky Conservative Risky Correlation between brain response to changes in predictability and risky behavior on decision-making task. NAc = Nucleus Accumbens Courtesy of P. Read Montague, Baylor School of Medicine

16. Dopamine • A primary reinforcer of fundamental learning • Makes us feel good when we make correct prediction under conditions of risk and uncertainty • “The dopamine system is more interested in reward than in punishment and more interested in novel stimuli than familiar ones.” --Wolfram Schultz

17. Courtesy Prof. P. Read Montague, Baylor School of Medicine

18. Dopamine Implications • Why does overconfidence not decline with expertise and experience? • Could availability be the residue of dopamine imprinting? • Unlikely payoffs trigger dopamine rush: so we play lotto, buy IPOs and invest with active managers • When anticipated reward fails to materialize, dopamine levels fall and depress mood: so we punish stocks that miss earnings even by a penny

19. The Amygdala • The seat of visceral, “hot” responses like fear and anger • Part of limbic system (“reptilian” or “lizard” brain) • Instant, instinctive reactions extending throughout the brain and body • Can trigger release of adrenaline, “fusing” memories of aversive emotion

20. Panel A: Increase in winnings activates L amygdala and hippocampus (and R inferior frontal gyrus) Panel B: Increase in losses activates R amygdala Source: T. Zalla, E. Koechlin, P. Pietrini, G. Basso, P. Aquino, A. Sirigu and J. Grafman, “Differential amygdala responses to winning and losing,” European Journal of Neuroscience, Vol. 12 (2000), pp. 1764-1770. Image courtesy of Jordan Grafman.

21. Trading with Your Amygdala? Transaction Costs (total basis points) Source: Ian Domowitz and Benn Steil, “Automation, Trading Costs, and the Structure of the Trading Services Industry,” Brookings-Wharton Papers on Financial Services, 1999, Table 6-1.

22. The Pre-frontal Cortex • the storehouse of experience, where past events and outcomes are preserved as emotional representations (or “structured event complexes”) • responsible for long-term planning and weighing future consequences of actions • draws general observations or conclusions from particulars • modulates emotional input from amygdala and other brain regions

23. The Iowa Gambling Task • The acts of gaining and losing are not just mental or emotional but profoundly physiological • Patients with PFC lesions cannot anticipate feeling of wins or losses. Will gamble to maximize short-term gains • Patients with amygdala lesions cannot experience feeling of wins or losses. Without emotional input, “rational” subjects will persist in a losing strategy

24. Courtesy of Antoine Bechara, University of Iowa

25. Courtesy of Antoine Bechara, University of Iowa

26. Courtesy of Antoine Bechara, University of Iowa

27. Courtesy of Antoine Bechara, University of Iowa

28. Courtesy of Antoine Bechara, University of Iowa

30. Courtesy of Antoine Bechara, University of Iowa

31. The Somatic Marker Hypothesis • Damage to amygdala impairs ability to experience emotion and encode events as “good” or “bad” • Damage to pre-frontal cortex impairs ability to re-experience an emotion by recalling past events • Why might scams prey on the elderly? • We make judgments not only by assessing probabilities and consequences, but also “(and primarily)” by evaluating their emotional attributes -- Antonio Damasio

32. Flex Your Cortex • The last time I was in similar circumstances, how did the outcome make me feel? • Antoine Bechara: try to build an “emotional registry” of experience • Alongside your trading records, keep feeling records -- especially important for younger investors

33. Soros’ “Emotional Registry” “My father will sit down and give you theories to explain why he does this or that. But I remember seeing it as a kid and thinking, Jesus Christ, at least half of this is bull---t. I mean, you know the reason he changes his position on the market or whatever is because his back starts killing him. It has nothing to do with reason. He literally goes into a spasm, and it’s this early warning sign.” --Robert Soros, describing his father George

34. The Prediction Addiction • the act of prediction can itself be addictive • we are hard-wired to make predictions • especially about repetition and alternation • alternation: prefrontal cortex • repetition: basal ganglia (near amygdala) • a brain that correctly predicts gain resembles a brain that’s “high” on drugs or sex • “I’m in control here” -- knowledge without awareness • what do other addicts always say?

35. Applications • Analyzing sequential data • Distract, interrupt, assign “secondary tasks” (Wolford, Gold & Hester) • Remember: your brain hates randomness! • Fight the prediction addiction • Rebalance • Seek out naysayers • Take the outside view, look at last blow-up • Trading for short-term: give job to a 95-year-old (R. Neuberger) • Learning from mistakes: build “emotional registry” • You are not just a thinking machine but a feeling machine

36. Future Directions • optical brain scans with near-infrared spectroscopy? • external magnetic stimulation? • reliable tests for risk tolerance? • ability to distinguish psychopathic risk-takers? • drugs to regulate dopamine, serotonin and other neurotransmitters? • efficient markets -- more or less?

37. Required Reading • Antonio Damasio, Descartes’ Error (Putnam, 1994) • Joseph LeDoux, The Emotional Brain (Simon & Schuster, 1996) • Paul Glimcher, Decisions, Uncertainty and the Brain (MIT, forthcoming 2002)