In the world of financial
decisions (investment, savings, intertemporal consumption, etc.), the emotional
component of decision-making plays a crucial role, despite the widespread
belief that financial markets are plenty of thoughtful cost-benefit analysis,
and complex, careful and rational expectations predictive models. Let's see
some topics of interest in Finance, but nuanced from the point of view of
modern Cognitive Neurosciences.
Temporal Preferences in the Brain
To study and model intertemporal
decisions, traditional economics has generally used the theory of discounted
utility, based on the idea that economic agents prefer a similar reward more if
it is obtained in the present than in the future; and similarly, future costs
would be less painful than the costs to be faced today.
To illustrate, empirical evidence
suggests that if a person is given a choice of $ 100 now or $ 110 tomorrow, he
generally prefers $ 100 now, while the same person if asked to select between $
100 in two years or $ 110 in two years and one day, it could get to prefer $
110 in two years and one day without any problem. It seems then that discount rates tend to be higher in the
short term than in the long term.
From the neuro point of view,
then the following questions arise:
- what is the mechanism behind these intertemporal decisions?
- do they arise from a single preference mechanism or from multiple systems that interact?
In seeking to answer these
questions, Samuel McLure, David Laibson, George Loewenstein and Jonathan Cohen[1],
using functional magnetic resonance imaging (fMRI), examined the neural
correlate of time discount while subjects made choices among monetary rewards
options that varied across time.
The experiment consisted of
giving the participants a choice between a sum in the short term and another in
the long term, the first being less than the second. Both options were
separated by a minimum time lag of two weeks, and in some pairs of options, the
earliest option was immediately available. The hypothesis was that the behavior
pattern of the two traditional parameters (β and δ) of the intertemporal
discount function arises from the joint influence of different neural
processes.
The β related to the limbic system and the δ related to the lateral
prefrontal cortex and other structures associated with higher cognitive
functions (the more rational ones). What results did the researchers obtain?
Basically, there would be two systems involved in such intertemporal decisions:
- · parts of the limbic system (emotional zone of the brain) associated with the dopamine system of the central brain, including the paralimbic cortex, which would be triggered by decisions involving immediately available rewards;
- · regions of the lateral prefrontal cortex and the posterior parietal cortex (eminently rational areas of the brain), uniformly involved in intertemporal decisions independently of the delay in time.
This neuroeconomic finding is consistent with the evidence that
consumers act impatient today but prefer to act patients in the future,
also supporting the hypothesis that different neuronal systems are activated by
intertemporal decisions: the impatience of the short term, which is driven by
the limbic system (emotional, not deliberative), and that responds preferably
to immediate rewards and to a lesser extent to future rewards; and long-term
patience, dominated by the lateral prefrontal cortex and associated structures
(the most deliberative parts of our brain), which can rationally evaluate
exchanges between abstract rewards, including rewards over longer periods.
Neurotransmitters of Financial Risk
In the securities markets it is
very often observed investors cut profits quickly, but that they endure losses
very much. This is because we humans have an innate tendency to avoid loss. We develop a series of brain
mechanisms to do everything possible to minimize them. We tend to mobilize much more with the fact of avoiding loss than with
the achievement of a profit.
The Neurosciences show that
certain regions of the brain, involved with the reward systems, are crucial to
forget (or diminish) the pain of financial losses. It is believed that a
neurotransmitter, norepinephrine, is essential for the response to loss of
money. Men with high levels of
noradrenaline are less sensitive to pain in the face of financial losses.
Another important
neurotransmitter, dopamine, also plays a crucial role in taking financial
risks. Several scientific studies find that increasing the levels of dopamine in healthy adults leads to choosing
investment / betting options that are riskier than the average.
Also recent neuroscientific
research has revealed the possibility that the endogenous hormones of stock
market agents, in particular, testosterone
and cortisol, can critically affect financial decision-making in markets.
Recent research shows that
cortisol, a hormone that modulates the response to physical or psychological
stress, predicts instability in financial markets. In a particular study[2],
samples of salivary levels of cortisol and testosterone were taken from people
who participated in a controlled experiment (142 sample people), and it was
found that the individual and combined
levels of endogenous cortisol predict subsequent risk assumption and
instability of market prices.
In summary, from the point of
view of Neurofinances, understanding the role of certain neurotransmitters and
/ or brain areas, both in intertemporal decision-making and in the
predisposition to assume excessive risks, will seem to play a predominant role
in the next years, with the idea of training
the brain in order to improve the investment performance, and not to reach
extreme situations of destabilization and volatility as they are often seen.
Author: Sebastián Laza (MBA, Neuroeconomist)
[1] Mc Lure, Samuel,
Laibson David, Loewenstein George and Cohen Jonathan, Separate Neural System Value Inmediate and Delayed Monetary Rewards,
Science, October 2004.
[2] Cueva,
Carlos; Roberts, R Edward; Spencer, Tom; Rani, Nisha; Tempest, Michelle;
Tobler, Philippe N; erbert, Joe; Rustichini, Aldo; Cortisol and Testosterone Increase Financial Risk Taking and May Destabilize
Markets. http://www.zora.uzh.ch/id/eprint/113359/2/cortisol%20and%20testosterone%20supporting%20material.pdf
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