Neuroeconomics

[Justin1987]

There's a burgeoning field in econ called "neuroeconomics." It explains the brain power behind decision making. For example, studies have come out showing that testosterone and cortisol affect trading. Has this been applied to trading? What progress is being made in this arena?

 

[Shakone]

There's a burgeoning field in econ called "neuroeconomics." It explains the brain power behind decision making. For example, studies have come out showing that testosterone and cortisol affect trading. Has this been applied to trading? What progress is being made in this arena?

In what way is neuroeconomics different from say Behavioural Finance/economics?

Things like risk aversion, loss aversion, utility are old ideas, and yes many of these things have been applied to trading.

 

[Justin1987]

The difference between neuroeconomics and behavioral finance is that the former looks at the brain chemistry involved. So for example, someone at 11am may have higher serotonin levels than at 2pm, which leads to a different set of behaviors since their brain chemistry is completely different. Or during a bear market, when cortisol levels explode in response to panic, traders may become far more risk averse and feel helpless than would be predicted given that their brain is changing the way they trade.

I'm curious if this has been explored, at all. Seems like understanding brain chemistry of traders could make a substantial difference in understanding/predicting behavior.

 

[Shakone]

The difference between neuroeconomics and behavioral finance is that the former looks at the brain chemistry involved. So for example, someone at 11am may have higher serotonin levels than at 2pm, which leads to a different set of behaviors since their brain chemistry is completely different. Or during a bear market, when cortisol levels explode in response to panic, traders may become far more risk averse and feel helpless than would be predicted given that their brain is changing the way they trade.

I'm curious if this has been explored, at all. Seems like understanding brain chemistry of traders could make a substantial difference in understanding/predicting behavior.

Ok, so it's more about the medical side and the causes rather than the effects. In terms of the actual effect, then that's behavioural finance and market psychology and has been explored a great deal, panics, crashes, bubbles, prospect theory. Also time of the day effects have been studied.

 

[Justin1987]

Thank you for the response Shakone, I appreciate it.

Yes the medical side is somewhat involved if by medical you mean the body and its chemicals. But I'm speaking more in terms of how brain chemistry affects decision making. It's not just the "cause" part of "cause and effect," because using the information can directly benefit the bottom line.

Let me give you an example. A study came out that says testosterone affects traders positively (the levels of the same trader; this isn't comparing traders with each other). A trader with higher testosterone levels on day 1 does SIGNIFICANTLY better than the same guy on day 2 when his test. is lower. This, by the way, is a real study. It's here: http://www.pnas.org/content/105/16/6167.abstract

Certain activities can raise testosterone levels. Let's say it's the 3rd friday of the month and futures are expiring. I want my traders to be especially risky today. I encourage my traders to exercise at 7am specifically on this day so their testosterone levels sore and it affects their trading.

That's just one example. There are other examples of how oxytocin, dopamine, etc. affect trading and decision making, but to be honest the research is still in its infancy.

I know behavioral finance has been looked into, but this is a bit deeper. Has this been explored that you know of?

 

[Shakone]

Hi Justin, from the abtract it's not clear from my quick reading which came first - the hormones or the results, i.e. if I'm having a good day then my testosterone increases, rather than I have a higher than normal testosterone and so I have a good day. Again, cortisol is related to stress, so it's no surprise that a losing trader or a trader taking on too much risk will have higher levels of cortisol.

It's an interesting topic, perhaps you can highlight some more examples and how it might be useful.

I don't know if it is deeper than behavioural economics though. Ultimately it's the effect that determines your bottom line. If say on a typical trading day [if there is such a thing ] Price moves sharply 8am-9:30am, then we get a reversal from 9:30am-11am, then we get a lunch time spike around 11:45-12am, then we get a reversal some time between 1:15pm and 3pm, then a lunch time spike at around 4:30-5pm,then we meander for a few hours. Now all of this is studied and if you can find some patterns like this hypothetical day I've given you, then you can potentially make money from it. Knowing that the sharp move at 8am is because of hormone levels early in the day or that the lunch time spike is because everyone is hungry is nice info to have, but doesn't really affect the bottom line in my opinion. A lot of people trade without needing to know the reasons.

So when you say, has it been explored, it's usually a pretty safe assumption that anything related to price movement has been explored. Even things for which there seems no connection, like the movement of planets for example have been explored. But whether a hedge fund has given a large number of their traders testosterone pills, I don't know. A lot of trading is algorithmic now, so there's that to consider too.

 

[Justin1987]

The abstract states that the levels of the hormones affected the P&L, so the higher testosterone was predictive of a higher profit margin.

When I say it's deeper than behavioral economics, I mean that NeuroEconomics is inclusive of behavioral economics. But you're correct, it's a very similar field, with the added component of neuro-biology. Here's an example of how I think it could be useful.

In October 2008 when the market crashed, as you remember there was a HUGE spike in volatility. That same abstract says there is actually a linear relationship between cortisol and volatility, so when volatility goes up traders immediately have markedly increased levels of cortisol. In the short term, cortisol makes you more focused, faster brain process...everything that makes a trader trade well. But after a few days of spiked cortisol, it has the opposite effect. People become weakened, risk averse, feel helpless, and are in a general state of panic. Furthermore, there is somewhat of a "group mimicry" effect, so that panic is contagious at chemical level.

There's already been extensive research on the behaviors of a panic, but not so much on the biological level. Now what if during that crisis, we've done research and have been able to predict how people will feel at a chemical level. I'm working at a hedge fund, and I'm monitoring the traders. We aren't surprised when the traders start panicking. We can take several steps to 1) limit the damage if we're in bad positions or 2) profit on the market. Steps beyond typical behavioral economics.

I would suggest monitoring for especially panicked traders and removing them from the floor so as to limit that "mimicry effect", looking out for tell tale signs of spiked cortisol and making sure traders follow a strict regimen to keep that down, encouraging a daily or weekly massage not just for relaxation but rather so that their oxytocin levels are normal.

Most importantly, knowledge is power.

The cortisol example is just one example, but the research is simply in its infancy. I think a company like Goldman or even moreso a company that *did* screw up like Bear Stearns would have benefited from understanding the neurobiology behind the crash. I'm pretty sure some companies have even experimented with a resident neuro-specialist.

 

[chump]

The abstract states that the levels of the hormones affected the P&L, so the higher testosterone was predictive of a higher profit margin.

When I say it's deeper than behavioral economics, I mean that NeuroEconomics is inclusive of behavioral economics. But you're correct, it's a very similar field, with the added component of neuro-biology. Here's an example of how I think it could be useful.

In October 2008 when the market crashed, as you remember there was a HUGE spike in volatility. That same abstract says there is actually a linear relationship between cortisol and volatility, so when volatility goes up traders immediately have markedly increased levels of cortisol. In the short term, cortisol makes you more focused, faster brain process...everything that makes a trader trade well. But after a few days of spiked cortisol, it has the opposite effect. People become weakened, risk averse, feel helpless, and are in a general state of panic. Furthermore, there is somewhat of a "group mimicry" effect, so that panic is contagious at chemical level.

There's already been extensive research on the behaviors of a panic, but not so much on the biological level. Now what if during that crisis, we've done research and have been able to predict how people will feel at a chemical level. I'm working at a hedge fund, and I'm monitoring the traders. We aren't surprised when the traders start panicking. We can take several steps to 1) limit the damage if we're in bad positions or 2) profit on the market. Steps beyond typical behavioral economics.

I would suggest monitoring for especially panicked traders and removing them from the floor so as to limit that "mimicry effect", looking out for tell tale signs of spiked cortisol and making sure traders follow a strict regimen to keep that down, encouraging a daily or weekly massage not just for relaxation but rather so that their oxytocin levels are normal.

Most importantly, knowledge is power.

The cortisol example is just one example, but the research is simply in its infancy. I think a company like Goldman or even moreso a company that *did* screw up like Bear Stearns would have benefited from understanding the neurobiology behind the crash. I'm pretty sure some companies have even experimented with a resident neuro-specialist.

The general usage of behavioural within this context refers really to explaining how some behaviours are learned ,and or possibly inherited. The Neuroscience approach differs because it assumes we can be considered as a Bio-machine. That our observable behaviour is initiated within the 'brain' of the machine and if we look at the brain and measure changes in it we might be able to predict the type of behaviour that accompanies those changes. By managing the underlying biology probably chemically we might be able to shape behaviour to change. It's much newer probably because of course it needed the Tech to be in place to facilitate it.

 

[Justin1987]

The general usage of behavioural within this context refers really to explaining how some behaviours are learned ,and or possibly inherited. The Neuroscience approach differs because it assumes we can be considered as a Bio-machine. That our observable behaviour is initiated within the 'brain' of the machine and if we look at the brain and measure changes in it we might be able to predict the type of behaviour that accompanies those changes. By managing the underlying biology probably chemically we might be able to shape behaviour to change. It's much newer probably because of course it needed the Tech to be in place to facilitate it.

Correct. The idea is to investigate the human bio-machine so we can understand/predict/influence/ behavior. That being said, like all science, neuroecon is an estimate of behavior and cannot predict events with 100% accuracy.

 

[Atilla]

There was a very interesting Horizon program on the decision making process.

http://www.bbc.co.uk/programmes/b03wyr3c

They referred to two systems 1 & 2. The first was instinctive and the latter entailed thinking, using the mind. The latter part of the program touched on Nobel Laureate Daniel Kahneman's behavioral economics.

In summary, most of our decisions are instinctive, more physical rather than considered and thought deduced.

Well worth watching the Horizon program if you get the chance. No longer on iplayer which is a shame.

 

[chump]

There was a very interesting Horizon program on the decision making process.

http://www.bbc.co.uk/programmes/b03wyr3c

They referred to two systems 1 & 2. The first was instinctive and the latter entailed thinking, using the mind. The latter part of the program touched on Nobel Laureate Daniel Kahneman's behavioral economics.

In summary, most of our decisions are instinctive, more physical rather than considered and thought deduced.

Well worth watching the Horizon program if you get the chance. No longer on iplayer which is a shame.

I watched it. It was very good. Indeed ,after you understand this stuff you begin to appreciate just how important it is to avoid doing the 'thinking' whenever possible. If you can construct methodology that removes as much bias as possible then you are well on the way to a winning outcome.
Gives one a certain perspective on expert/analysts opinions on market issues best summed up as ;the two most dangerous words in the financial lexicon "I Think".

 

[teflon142]

Thank you for the response Shakone, I appreciate it.

Yes the medical side is somewhat involved if by medical you mean the body and its chemicals. But I'm speaking more in terms of how brain chemistry affects decision making. It's not just the "cause" part of "cause and effect," because using the information can directly benefit the bottom line.

Let me give you an example. A study came out that says testosterone affects traders positively (the levels of the same trader; this isn't comparing traders with each other). A trader with higher testosterone levels on day 1 does SIGNIFICANTLY better than the same guy on day 2 when his test. is lower. This, by the way, is a real study. It's here: http://www.pnas.org/content/105/16/6167.abstract

Certain activities can raise testosterone levels. Let's say it's the 3rd friday of the month and futures are expiring. I want my traders to be especially risky today. I encourage my traders to exercise at 7am specifically on this day so their testosterone levels sore and it affects their trading.

That's just one example. There are other examples of how oxytocin, dopamine, etc. affect trading and decision making, but to be honest the research is still in its infancy.

I know behavioral finance has been looked into, but this is a bit deeper. Has this been explored that you know of?

The auther of this paper was the tutor of a trader that used to post on this board. Both were interviewed on the radio (live). Hilarity ensued.

 

[teflon142]

The physiology of trading has been long been researched and coached - heart rate variability, effects of excercise and diet etc.

 

[PieterSteidelmayer]

There was a very interesting Horizon program on the decision making process.

http://www.bbc.co.uk/programmes/b03wyr3c

They referred to two systems 1 & 2. The first was instinctive and the latter entailed thinking, using the mind. The latter part of the program touched on Nobel Laureate Daniel Kahneman's behavioral economics.

In summary, most of our decisions are instinctive, more physical rather than considered and thought deduced.

Well worth watching the Horizon program if you get the chance. No longer on iplayer which is a shame.

Don't have access to the programme but have studied Kahneman and Tversky et al.

If I remember correctly, it's not so much that we spend most of our time in mode-1 auto-pilot knee-jerk that is the issue, it's the belief most have that they're really making all their mode-1 decisions in the much slower and deliberate mode-2 rational/logical mode. Then they wonder why they feel bad about so many of their decisions.

A way out of this feeling bad is to either acknowledge that the majority of your decisions are made in mode-1 where they're made virtually instantaneously, instinctively and take responsibility, without regret, for those decisions that were less useful on the basis that those which were, were made quickly and effectively

Or, slow down and really consciously employ mode-2 rational and logic to every (important) decision. For instance, if you're trading when you do have a choice on modes.

You may not have any better results with the latter approach, but you'll have less buyers/sellers remorse.

The apparent need to act instinctively and quickly (mode-1) seems to be a function of the lower trading timeframes. Those trading longer timeframes have less buyers/sellers remorse and, strangely enough, higher profitability.

Who knew?

 

[zenzaa]

new science:
The human being does not act neither rational nor efficient when it comes to dinero.Sus financial decisions are not based on reason but that they often come into play more uncontrollable as are the feelings or intuitions elements.
Researchers, instead of observing the behavior of the subject, use of the image (MRI) technologies to see which areas of the brain are active during these experiments. One of the games is the "ultimatum" and has been studied by Dr. Jonathan D. Cohen, a professor of cognitive neuroscience at Princeton University, United States. The results of this study were recently published in the journal Science.
The $ 10 game

Dr. Cohen and his team took brain scans of people who played it. The game consists of the following: Player A has $ 10 and can provide the amount you want the player B. If player B accepts the offer, the money is distributed, but if not, neither players get nothing.

Most players who embodied the role B rejected offers two and three dollars, preferring to penalize the player A before you feel cheated. This obviously goes against economic logic, I would say it is better to stick with something to lose everything, says Dr. Cohen told The New York Times.

Brain imaging showed that when players accepted, a circuit located on the front of his brain, which supports the deliberative thought was put into operation.

However, when they rejected the offer, the insula, which monitors states of the body, including the disgust dominated the front circuit. The stronger that domain, the faster the player rejected the offer.