Irrational Exuberance Observed When It Comes To Investing
July 8, 2014

Irrational Exuberance Observed When It Comes To Investing

Brett Smith for - Your Universe Online

“(Investors) should try to be fearful when others are greedy and greedy when others are fearful,” Warren Buffett famously wrote in 2004.

Now, a new study has confirmed that The Oracle of Omaha knew what he was talking about as researchers from Caltech and Virginia Tech have found that during economic bubbles, wise traders receive an early warning signal from their brains telling them to sell, according to a report in the Proceedings of the National Academy of Sciences.

"Stock market bubbles form when people collectively overvalue something, creating what economist Alan Greenspan once famously called 'irrational exuberance,'" said study author Read Montague, director of the neuroimaging laboratory at the Virginia Tech. "Our experiments showed how the collective behavior of market participants created price bubbles, suggesting that neural activity might offer biomarkers for the evolution of such bubbles."

For the study, the research team registered 320 participants in a market-trading simulation game. Up to 24 volunteers took part in each of 16 market sessions, with two or three volunteers having their brains scanned during the sessions using functional magnetic resonance imaging (fMRI).

During the 50 trading intervals of each trading period, a price bubble would inevitably form and crash. The scientists suspected that crowd mentality would cause some bubble formation, although they had not expected it to happen each time.

"The first thing we saw was that even in an environment where you don't have squawking heads and all kinds of other information being fed to people, you can get bubbles just through pricing dynamics that occur naturally," said study author Colin Camerer, a behavioral economics professor at Caltech. This finding runs counter to the popular belief that bubbles are caused by hype or bad information.

The scientists split the volunteers into three categories founded on their earnings during their 50 trading periods: low, medium, and high earners. They discovered that the low earners started purchasing as prices went up after which they kept acquiring assets even as prices fell. The middling traders didn't take a lot of risks by any means and, because of this, neither produced nor dropped large amounts of money. The traders who earned the most bought earlier and even sold when the market was still rising.

"The high-earning traders are the most interesting people to us," Camerer said. "Emotionally, they have to do something really hard: sell into a rising market. We thought that something must be going on in their brains that gives them an early warning signal."

The fMRI imaging revealed brain activity in a region called the nucleus accumbens (NAcc) lit up in all participants when they were told what they had earned last trading period and when shares were bought or sold. The NAcc is associated with reward processing so researchers said they were not surprised to see it activated when traders found out how their moves paid off.

They also saw that low earners appeared to be very sensitive to activity in the NAcc, while high earners were less sensitive.

"That is a correlation we can call irrational exuberance," Camerer said. "Exuberance is the brain signal, and the irrational part is buying so many shares. The people who make the most money have low sensitivity to the same brain signal. Even though they're having the same mental reaction, they're not translating it into buying as aggressively."

In high earners, researchers also saw activity in an area known as the insular cortex increase shortly before they switched from buying to selling.

"The prices were still going up at that time, so they couldn't be making pessimistic predictions just based on the recent price trend. We think this is a real warning signal,” Camerer said.

"It's notoriously hard to identify stock market bubbles and predict crashes by tracking price fluctuations alone," he added. "This experimental method is ideal for understanding the neuropsychology of bubble formation, because we can control the fundamental values and use both prices and brain activity to figure out why bubbles form and crash."