Friday, November 05, 2010

Why our brains go for market bubbles.

Jonah Lehrer has a nice piece in last Sunday's New York Times Magazine which discusses Read Montague's work suggesting that financial manias seem to take advantage of deep-seated human flaws; the market fails only because the brain fails first.
At first, Montague’s data confirmed the obvious: our brains crave reward. He watched as a cluster of dopamine neurons acted like greedy information processors, firing rapidly as the subjects tried to maximize their profits during the early phases of the bubble. When share prices kept going up, these brain cells poured dopamine into the caudate nucleus, which increased the subjects’ excitement and led them to pour more money into the market. The bubble was building.

But then Montague discovered something strange. As the market continued to rise, these same neurons significantly reduced their rate of firing. “It’s as if the cells were getting anxious,” Montague says. “They knew something wasn’t right.” And then, just before the bubble burst, these neurons typically stopped firing altogether. In many respects, these dopamine neurons seem to be acting like an internal thermostat, shutting off when the market starts to overheat. Unfortunately, the rest of the brain is too captivated by the profits to care: instead of heeding the warning, the brain obeys the urges of so-called higher regions, like the prefrontal cortex, which are busy coming up with all sorts of reasons that the market will never decline. In other words, our primal emotions are acting rationally, while those rational circuits are contributing to the mass irrationality.


  1. Anonymous2:30 PM

    Utter nonsense. To invoke neuro-based arguments to explain market bubbles suggests that the writer receives a dopamine reward for intellectual masturbation.

    There are many possible explanations for market bubbles. The challenge for the serious thinker is to appropriately frame the problem.

    One could frame the problem in game theoretic terms. For example we have a tragedy of the commons problem a kin to fishing. IF we all continue to fish we will exhaust the stock of fish and all starve. If any one elects to stop fishing they starve. Coordination is needed to resolve the matter. Thus in the market bubble situation we can stop playing and deliver inferior returns immediately or trade until we all lose. Losing later is preferable to most humans.

    Please note there is no irrational behavior to explain. Dopamines may be in force across all players but it is not predictive.

    Cooperation is necessary to modify the rules of the game. Given that players are strictly forbidden to cooperate by law we have a problem where the game as regulated creates the outcome. We now have an explanation that the market failed not do player actions but regulator actions. The recent economics winner (2009) offers interesting approaches to dealing with this type of problem.

    Dopamine and Testosterone explanations have no real place. They are at the wrong level. Rules not player psychology is the issue.

    While this is but one possible explanation. It appears far more likely given the levels issue. I suggest that we do not see the world through our pet theory, rather look at what really is happening.

  2. Anonymous, you begin by stating "There are many possible explanations for market bubbles." Then go on to state that "Dopamine and Testosterone explanations have no real place." because they are "at the wrong level".

    The explanations aren't mutually exclusive regardless the perceived "level". That you would suggest our neurons play no role in market behavior is, as you put it, utter nonsense.