Neuroeconomics: The Brains Behind the Investment

One area where the growth of neuroscience has been particularly notable in recent years is economics.

It may, at first, seem a strange relationship, but neuroscience has allowed us to better understand how the brain works and how decisions are made. This is key to understanding investment decisions, so, when viewed in this light, it is a perfectly natural connection to make.

Studies on risk: the investing brain

A recent U.S. study looked at the effect of different levels of monetary risk on the human brain. 61 participants were asked a variety of questions such as “Would you prefer a 50 percent chance of receiving $5 or would you rather take a 13 percent chance of winning $50?” and “Would you prefer $10 for sure or a 50 percent chance of receiving $50?”

It was found that the make up of the gray matter of participants’ brains contributed to the levels of tolerance to risk; the more gray matter in the right posterior parietal region of the cortex, the riskier the responses.

While this study has some interesting findings, it is limited and its major importance is in demonstrating the types of relationships that are currently being investigated through neuroscience. This is a taste of things to come, as scanning methods become even more advanced and more specialists are able to interpret the data.

This coming together of economics, neuroscience and psychology has given rise to ‘neuroeconomics’, which has advanced the understanding of economic decision-making.

In the past, economic models have been designed with little understanding of how the human brain works. Predictive models were designed by economists who understood the mathematics very well, but the models would repeatedly fail due to a lack of allowance for human behaviour.

Understanding more about how the brain influences decision-making and thus behaviour is therefore a major breakthrough as economists can include more realistic models of choice.

The choosing brain

Studies have helped to demonstrate that people generally become more risk-averse as they age; and this would seem to correspond with a thinning of the brain’s cortex in older age.

This has consequences for important financial decisions that aging people need to make like choosing the most suitable retirement or health plan; even the most intelligent older adults can make errors and can lose money through very simple mistakes in the selection process.

Traditional models can now accommodate more of what we know about the decision-making of aging brains, for instance, by providing clearer options and simplifying the process of making financial choices. By presenting options in such a way that it plays to the strengths, not weaknesses of the brain, makes it less likely that expensive errors will be made amongst the elderly. It also reduces the need for a ‘trial and error’ type of approach, making policy design better.

The trading brain

Another area of economics that has come under the microscope from neuroscience is trading. The interest in what is going on in the brain when traders make their decisions to buy or sell is not surprising, given the huge stakes.

A U.S. study earlier this year looked at trading success and how it was associated with areas of the brain associated with reward and response to gut feelings.

One of the findings from the study was that an area called the ‘nucleus accumbens’ (associated with reward) was more active and excited when prices rose; the second key finding was that the more successful traders received signals from the ‘anterior insular cortex’, which is an area that is active during bodily discomfort and unpleasant emotional states: like an in-built warning to sell before a bubble bursts.

Brian Knutson, a neuroscientist at Stanford University, interpreted the findings like this:

“This research shows that neural signals not only correspond to but predict important financial events in an experimental market.”

Perhaps this is how the likes of Warren Buffett do so well, while others fail? Does he receive brain signals and gut warnings when to buy and sell? It’s an intriguing thought and one of the many questions that neuroscience throws up in the field of economics.