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3 reasons why wealth managers should study neuroscience

Neuroscience of financial decision-making, also known as Neurofinance, is the study of decision-making under uncertainty that uses methods derived from human neurosciences (such as neuroimaging, psychophysiology, hormone level measurements, neurocomputational modelling) on human participants performing financial or economic decision-making tasks. If you haven’t heard of neurofinance before, think of it as the neurobiological extension of psychology of finance that not only shows how humans behave in situations of investment, trading, winning and losing money, but also captures the underlying brain and nervous system functioning.

 

Ewa Lombard, PhD
Neuroscientist, Assistant Professor                                                 

 

Here are three interesting things I learned studying neuroscience of finance:

 

Financial decision-making is not a battle of reason with emotion in the brain

Rather, emotions are useful and necessary signals for financial decisions. Research confirmed that awareness of own bodily signals which track emotions is related to risky decision-making. Andrew Lo and his team from MIT showed in an experiment on New York stock exchange traders: their heart rate correlated with mean stock market volatility (2002). This was the moment when emotions were first taken seriously as inner indicators of cognitive processes in reaction to changes in risk and value in the marketplace. In 2016, an experiment on London day traders demonstrated that men with better interoception (awareness of own bodily signals) also have better profitability and survive longer in the profession. Besides these, there is much further evidence that listening to the body’s subtle emotional signals can lead to better investment choices in the stock market context, especially in experienced professionals. In short, neuroscientific experiments have demonstrated the role of emotions in the phenomenon of “gut feeling” that indeed conveys a bodily signal into the brain area that governs interoception and risk perception.

This knowledge is useful beyond simple self-awareness. Despite the surge in algorithmic trading, humans and their biases still dominate prices of some assets. Cryptocurrencies, for instance, exhibit typical emotional waves with overoptimistic rise in price (greed, overconfidence, optimism bias) and lingering decline in price as investors lose hope but exit too slowly (disposition effect, uncertainty, negative expectation). These emotions in the reversal and in the late momentum produce neural-induced market inefficiencies that can be exploited by innovative neural and technical indicators based on computational neuroscience to obtain uncorrelated alpha (see for instance, https://www.neuronomics.com/ ).

 

Your brain is not “irrational”, it needs error to learn

Not all economic choices are irrational and biased. The concept of “irrationality” is based on a comparison that is, I daresay, detached from biological reality. Rationality in the traditional economic view assumes that people have consistent preferences, possess all relevant information, and make choices that are optimal given their constraints. It implies that “agents” make decisions that are consistent with their own preferences and available information, which is not the case as human brains are wonderfully adaptable prediction machines that work a bit like the auto-complete on your smartphone and are designed to learn from error and reinforcement. This can explain, for example, anchoring, optimism, and hindsight bias.

Many of the economic biases can be explained by our limited attention and processing capacity, and also by the fact that the brain does not process information in real time but rather makes a prediction to which it later compares reality by means of a prediction error. That prediction is usually based on past experience, giving rise to biases such as overoptimism. The recency bias can be explained by the fact that our memory fades with time and is reconstructive in nature (and not a computer-like database).

Neuroscience has also shown that in some decisions engaging in economic optimization is biologically impossible due to the brain’s computational capacity. However, the brain’s prefrontal cortex evaluates choices under uncertainty when they are made from experience, based on mean-variance analysis, just like in portfolio theory. Decisions from description are more prone to biases (such as overweighting of small probabilities and attention to extreme values as described in prospect theory) because they are computed in a different circuit of the brain.

 

Sex differences can drive stock market prices

There are major biological differences between the sexes when it comes to financial decision-making. Many psychoneuroendocrinology experiments have studied the role of two hormones – testosterone and cortisol – in financial decision-making, mostly in a stock market context. For example, brokers with a high level of testosterone, the primary male sex hormone, are more prone to taking risks and make more stock market gains. In parallel, an investor’s growing optimism after a winning streak can be explained by an effect produced by testosterone, in which the winner’s hormone level increases, while the loser’s drops. These analysis parameters can help to understand market changes depending on the sex of the decision-makers.

 

Neuroscience can be used to provide investors with better advice

In summary, neuroscience and psychology of financial decision-making offer useful insights for anyone dealing with people making financial decisions. Numerous pertinent topics, such as the behavioral consequences of income inequality, the ins and outs of sustainable investment, moral decisions, and individual differences, can be used to provide investors with better and more confident advice.

This article is based on a series of seminars offered as part of the SFAA's continuing education programme. You can find the complete offering under this link.

 

 

Biography

Dr Ewa Lombard (Miendlarzewska), Assistant Professor at Montpellier Business School, specializes in the neuroscience and psychology of sustainable decision-making, especially in financial decisions. She is a neuroscientist based in Geneva with a background in management and corporate experience and her mission is to bring more human nature to business decision-making. Author of "Neurofinance", her research also includes focus on ethics and future modes of work, as well as intergenerational discounting. Besides teaching, she offers lectures and workshops in Neuroscience of Financial Decision-Making and in for practitioners.