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How brain science explains market bubbles and ‘irrational exuberance’

“Buy low, sell high” is always good advice.

But according to a new study published this week in the journal Proceedings of the National Academy of Sciences, not everyone’s brain is equipped to take it. Some traders get an “early warning signal” that causes them to sense a bubble and pull out. Others don’t get it, and continue buying until the bubble bursts.

Researchers from the California Institute of Technology and Virginia Tech led by Alec Smith and Colin Camerer studied the brain activity of traders, students in this case, in a faux market in the middle of a price bubble.

They found the most successful traders were prompted to sell before the bubble burst by a warning signal from a part of the brain that triggers feelings of discomfort. Less successful traders who bought aggressively while prices were rising didn’t get that crucial “sell” signal.

What these researchers wanted to know is whether traders’ neurology makes bubbles bubble or, put another way, whether there’s something going on in the brain that controls their “irrational exuberance,” the term made famous by former Federal Reserve chairman Alan Greenspan.

To answer the question, they created an online trading market. About 20 subjects were given 100 units of fictional currency and six shares of a fictional risky asset.

The researchers recorded the traders’ decisions to buy, sell or hold shares in 50 trading periods during which the asset’s price varied greatly.

During these sessions, researchers did MRIs on some subjects to measure activity in two parts of the brain: the nucleus accumbens — the pleasure and reward center — and the anterior insular cortex, a part of the brain tied to pain, anxiety, discomfort and disgust. Previous studies have shown this part of the brain is activated when people take financial risks.

The researchers found activity in the pleasure center of the brain spiked when traders were shown how well their gambles in previous trading periods had paid off. The brain activity in the pleasure center could even predict future changes in the price of risky assets, they found.

For high-earning traders, however, activity increased in the risk-detecting part of the brain shortly before the traders 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,” one of the researchers, Cal-Tech’s Colin Camerer, said in a press release.

However, the majority of subjects — ultimately low-earning traders — didn’t get that signal. They gave over to irrational exuberance.

“The high-earning traders are the most interesting people to us,” Camerer says. “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 signal might be mental — an increased perception of risk — or even physical, such as an uncomfortable bodily state.

One thing this brain activity suggests is that price bubbles aren’t entirely attributable to external forces.

“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 Camerer.

Might the brain work the same in real markets, as opposed to the lab? “Given that the results match many intuitions about getting ‘caught up’ in the bubble and being wary of a crash,” Camerer said in an e-mail, “we have some confidence that the results are likely to be general in a lot of types of natural markets, not just our simple ones.”