Founded in 1993, Long Term Capital Management's team of financial superstars included Myron Scholes and Robert Merton who were awarded the Nobel Prize in economics in 1997 for their work on derivatives and financial risk analysis. Back by a world-class team of financial wizards and supported by the latest mathematical modeling supercomputers, LTCM quickly became a major global playeri n relative value trading.

In the summer of 1998, however, LTCM’s reliance on mathematical models almost brought the entire global financial system to its knees. Among the many mistakes LTCM made, they did not take into consideration the emotional responses that financial trader’s would make in stressful situations. According to their models, and standard economic theory, a bond that is too cheap should attract buyers. Following this logic, they would buy contracts at very low prices in order to increase the spread that they would receive when selling the contract in the future.

As LTCM later admitted, their models were not fully aware of market price dynamics. In fact, in a “skittish” market, lower prices can actually act to repel buyers as they avoid becoming involved with more potentially painful situations. This failure represented such a profound threat that the Federal Reserve found it necessary to help organize the effort to forestall LTCM’s bankruptcy.

The lesson from LTCM is clear; people are not the rational actors standard economic theory would make them out to be. Instead, our emotional reactions to future events play an important role in our decisions. While there has been a longstanding controversy in economics as to whether financial markets are governed by rational forces or by emotional responses, neuroeconomists have recently shown that emotions profoundly influence the decision-making process. This is the essence of neurofinance.