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July 21, 2005

Neuroeconomics Research Driving Evolving Neurofinance Field

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Posted by Zack Lynch

A recent study published in the Journal of Psychological Science and reported in today's Wall Street Journal showed that a group of individuals with brain damage to some of the more sensitive emotional regulatory areas in the brain made more profitable investment decisions than a control group with no known brain damage. Out of the 41 participants, the 15 "brain-damaged" individuals achieved approximately 10% more profitable results than their normal counterparts.

The neuroeconomics study conducted by researchers from Carnegie Mellon University, Stanford Graduate School of Business and the University of Iowa, used neurodiagnostic systems such as brain imaging and genetic analysis to show how risk-aversion can impede "rational investment decisions."

Applied neuroeconomics, or neurofinance, is already taking hold on Wall Street as David Darst, chief investment strategist in the Individual Investor Group at Morgan Stanley pointed out in the article, "this (neuroeconomics) branch of inquiry and economic investigation is really fortifying and buttressing our understanding of investor behavior...and is already informing our tactical decisions."

Most interesting, however, is the buried fact that 3 of the brain damaged investors had experienced personal bankruptcy.

So does this show how debased financial markets are from reality or reveal an inefficiency in how humans have adapted to our evolving social digital ecological? As George Lowenstein, professor of economics at CMU, noted "Human beings are pathologically risk averse...There were no such things as stock in the Pleistocene era."

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August 11, 2004

Neurofinance in Practice (II)

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Posted by DavidE

by David Edwards

While mainstream financial theory remains dominated by the efficient markets proponents, some famous—such as Warren Buffet--and some not so famous--such as John Hussman--money managers have been making money based on market inefficiencies. Hussman, who manages the Hussman Family of Funds, uses an investment style that is based on capturing these inefficiencies, and he has a remarkable track record from 2000-2004 of consistently beating the market with low volatility of returns. There are also mutual funds based on behavioral finance principals. How then does neurofinancial theory relate to these market inefficiencies and what possible money making applications arise from it?

While we know markets are comprised of individual traders and that their actions as a group help create price discovery, it is a bit of a leap to assert that an individual trader's physiological make up affects the overall behavior and pricing of financial markets.

Neurofinance research will help make this case by examining how individual make up impacts the decisions that traders make. It is interesting to note that many traders are not trained per se, at least in the formal sense that business executives, musicians, athletes, and other professionals are, but rather are thrown into a Darwinian competition where survival entails not being wiped out. Apart from the problems with this method indicated by survivorship bias, which asserts that a certain percentage of traders survive and thrive by sheer luck or chance, and about which Nasim Taleb has written extensively in "Fooled By Randomness", we should consider why we do not take a more scientific approach to the training and assessment of traders.

Why it may seem strange or even unethical to envision screening and testing potential traders by scanning their brain and testing their blood chemistry, it was not long ago that testing lactate threshold and VO2 max, which is now routine for swimmers, runners, and other endurance athletes, was considered avant garde. This type of testing, not only offers insight into a person's natural ability based on heart size, aerobic capacity and other biological characteristics, but also provides critical biofeedback before, during and after performance. This is the basis upon which Sandia Labs is developing its anthroscope project, i.e. that biofeedback can offer real time information to teams in learning situations that allows them to alter their behavior in midstream and improve outcomes. A logical next phase is to apply these technologies and knowledge to traders and trading.


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August 09, 2004

What is Neurofinance?

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Posted by DavidE

This week David Edwards will explain in a three part series the basics of neurofinance, its history and potential practical applications.

What is Neurofinance? by David Edwards

Neurofinance is a new science that analyzes financial markets by applying neurotechnology to trading behavior. The goals of neurofinance are:

1) to improve trading results and our understanding of financial markets by identifying which physiological traits affect trading behavior

2) to correlate these traits with trading success (or failure), and

3) to develop tools, technology, and training methods to improve trading performance.

Neurofinancial theory holds that our inability to behave rationally is rooted in our psychophysiology. Because neurofinance is based on the assumption that individuals have varying psychophysiological make-ups, which in turn play a strong role in both their ability to make rational decisions and in their success as financial market operators, it represents a contrary approach to that of the efficient market hypothesis (“EMH”). EMH, the theory upon which most of modern finance is based, as well as its antecedent, utility theory, contain the implicit precondition that humans generally act out of rational self-interest, and will behave accordingly when faced with economic decisions. In other words, that people will make the most rational and efficient economic choice no matter the situation or conditions. We all know, of course, that in real life, this is not always the case. The question is why?

More Focused than Neuroeconomics

Though neurofinance is still in its infancy, its ancestors and cousins include behavioral finance, behavioral economics, behavioral game theory, and neuroeconomics. While the first three have employed concepts from the behavioral sciences, in particular social psychology, the later has relied on neuroscience techniques that image brain activity, such as PET scans and fMRI.

One way of looking at the difference between the behavioral approach to finance and economics and the neuroscientific approach, is that the former observes how people act and interact when they make economic or financial decisions and interprets these actions according to established psychological concepts, while the later investigates why these behaviors occur based on our brain and hormonal activity.

What distinguishes neurofinance from neuroeconomics, though they use many of the same techniques, is that while neuroeconomics seeks to understand the physiological basis for making economic decisions, neurofinance focuses more narrowly on trading and financial markets.

On Wednesday David will explore some potential research areas in neurofinance.

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July 22, 2004

You Bet Emotions Matter - Just Remember LTCM

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Posted by Zack Lynch

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.

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May 14, 2004

Brain Scanning Accelerates Neurofinance

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Posted by Zack Lynch

Randall Parker's post Brain Scans Show Money Gained From Good Performance More Meaningful is an excellent example of the progress being made in the neuroeconomics field.

Money that comes as a result of reasons unrelated to one's own performance causes less activity in the area of the brain associated with reward processing than when the money comes as a result of good performance. (same article here)

Human beings are more aroused by rewards they actively earn than by rewards they acquire passively, according to brain imaging research by scientists at Emory University School of Medicine. Results of the study, led by first author Caroline F. Zink and principal investigator Gregory S. Berns, MD, PhD, of Emory's Department of Psychiatry and Behavioral Sciences, are published in the May 13 issue of the journal Neuron.

The Emory scientists used functional magnetic resonance imaging (fMRI) to measure brain activity in the striatum, which is a part of the brain previously associated with reward processing and pleasure. Although other experiments have studied and noted brain activity associated with rewards, until now these studies have not distinguished between the pleasurable effects of receiving a reward and the "saliency" or importance of the reward.

Study volunteers in the Emory experiment were asked to play a simple target-detection computer game. During the game, a money bill appeared occasionally and automatically dropped into a bag of money on the screen. The participant was given the amount of money that dropped in the bag at the end of the game, but because receiving the money had nothing to do with their performance on the computer game, it was not particularly arousing or salient to them.

In another version of the game, a money bill occasionally appeared on the screen and the participant had to momentarily interrupt the target detection game and push a button to make the bill drop into the bag. In this case, whether or not the participant received the money did depend on their performance, which made the appearance of the money bill more salient to them.

In yet another version, participants played the same computer game except the bag on the screen did not appear to have money in it and a blank "blob" dropped into the bag instead of money.

The investigators performed fMRI on the subjects while they were playing the game, particularly focusing on the reward centers. They found that some reward centers of the brain were activated whenever the money was received, but that other parts, particularly the striatum, were activated only when the participants were actively involved in receiving the reward.

"Scientists have conducted tests with monetary rewards in the past and noted that the striatum was activated, but it has been unclear whether it was because of the pleasure surrounding the money or the fact that the money was presented to participants in a salient or behaviorally important manner," said Zink. "We differentiated the saliency aspect by having the participants receive money that had nothing to do with their actions and having them receive money through active participation."

The investigators confirmed that the appearance of money that required a response was more salient to participants than money received passively by measuring skin conductance responses during the game -- a measurement of general arousal used as part of lie detector tests. The active participation in receiving the reward was the only condition that elicited a higher skin conductance measure, indicating greater arousal.

"Being actively engaged in the pursuit of rewards is a highly important function for the brain, much more so than receiving the same rewards passively," Dr. Berns explains. "It is like the difference between winning the lottery and earning the same amount of money. From the brain's perspective, earning it is more meaningful, and probably more satisfying."

It makes sense from an evolutionary perspective that the brain is wired up to reward itself for successfully engaging in activities that bring gains to one's position. History has already provided copious quantities of evidence that the political philosophy of Karl Marx is incompatible with human nature. Even before communist revolutionaries swept into power there were older theories of human nature that predicted the failure of a creed based on "from each according to his ability and to each according to his need". But advances in brain imaging technology has produced tools that are allowing reductionist brain scientists to start unravelling the deep seated mechanisms of our brains that alwayts doomed Marxism to failure.

A more general observation here is that by discovering the mechanisms that govern our behavior science is discovering limits to the malleability of human nature. As brain science advances its results are increasingly going to be used to judge whether proposals for changes in social order are going to compatible with human nature as science comes to understand it. Radical advocates of new social orders are going to increasingly be challenged by results from scientific research labs.

However, science will not only play a conservative role in opposition to proposed changes. Some proposals will be found to be compatible with human nature. Also, and more worringly, eventually scientific advances in the understanding of the brain and in ways to manipulate neurons will serve as the foundation for the development of technologies for changing human nature. Any future radicals who manage to seize power will be able to use biotechnologies to rework the brains of their subjects to be compatible with their imagined utopias. We will no longer be able to count on human nature to serve as a source of resistance to radical utopians because human nature will become more malleable.

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May 07, 2004

Neurofinance - Profitable Mind Management

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Posted by Zack Lynch

Financial organizations have always been at the forefront of adopting, testing and disseminating the latest driving technology. Always searching for the latest way to increase transaction effectiveness and improve decision accuracy, financial analysts have continuously sought out the latest tools to attain competitive advantage.

During the water mechanization wave (1770-1820), banks were among the first organizations of penny post which partially relied on cheaper transportation costs afforded by the build out of canals throughout England. Most recently, we witnessed during the 1970s and 1980s the emergence of a global financial trading system allowing instant currency and financial movements which at the core was built on the back of microchips. The neurotechnology wave will be no different.

With instantaneous information at their fingertips, information or the ability to analyze and act on it is no longer the competitive differentiator it was for financial traders. In fact, information overload is increasing stress levels and impacting the emotional effectiveness of today's financial traders. In a brilliant paper written in 2002 by Lo and Repin's -- The psychophysiology of real-time financial risk processing -- they analyze this very point:

"A longstanding controversy in economics and finance is whether financial markets are governed by rational forces or by emotional responses. We study the importance of emotion in the decision-making process of professional securities traders by measuring their physiological characteristics (e.g., skin conductance, blood volume pulse, etc.) during live trading sessions while simultaneously capturing real-time prices from which market events can be detected."

As I've written previously in Forecasting happiness, Finance with feelings, and
Anthroscopes to improve team productivity, emerging neurotechnologies will increasingly be used by financial institutions to attain neurocompetitive advantage.

While some continue to question the validity of neuromarketing, interest in neurofinance is quickly gaining attention. Today companies like HeartMath and Quantum Intech are focused on providing biofeedback management techniques, while those on the cutting edge are seeking out the nexus of neuroscience and the financial markets: real-time neurofeedback.

Wouldn't you want the best tools humanity could develop if you had billions of dollars on the line?


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January 23, 2004

Anthroscopes Improve Team Productivity

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Posted by Zack Lynch

No theory yet exists to explain why or how groups perform optimally, but this hasn't stopped researchers at a Sandia National Laboratories' Advanced Concept Group from trying to map the characteristics that correlate to “personal-best” performances.

Using all commerically available components, the team has created an anthroscope, called PAL. This anthroscope monitors your perspiration and heartbeat, reads your facial expressions and head motions, analyzes your voice tones, and correlate these to keep you informed with a running account of how you are feeling. It also will transmit this information to others in your group so that everyone can work together more effectively.

Technologies used in the project included — accelerometers to measure motion, face-recognition software, EMGs to measure muscle activity, EKGs to measure heart beat, blood volume pulse oximetry to measure oxygen saturation, a Pneumotrace™ respiration monitor to measure breathing depth and rapidity.

Preliminary results on five people interacting in 12 sessions beginning Aug. 18 indicate that personal sensor readings caused lower arousal states, improved teamwork and better leadership in longer collaborations. A lowered arousal state — the amount of energy put into being aware — is preferable in dealing competently with continuing threat.

“In 2004 we intend to integrate simultaneous four-person 128-channel EEG recording,” says team leader Peter Merkle, “correlating brain events, physiologic dynamics, and social phenomena to develop assistive methods to improve group and individual performance.”

Check out the video of the anthroscope in action.

As discussed in Forecasting Happiness and Understand Emotions, Become Profitable, it sure looks like it won't be long before Wall Street traders start using anthroscopes to understand how their feelings impact their trading effectiveness.

Update: It is important to note that this technology is being developed for national security purposes. (see the Augmenting Cognition Program for more on this). Teams like intel opcenters, security monitoring centers at sites, and combat opcenters special teams. These are people who are willing to give up some personal privacy in exchange for privilege of serving others.

Note: For those of you that are interested, Sandia is supporting a $50,000 graduate fellowship to study the neurology of learning processes under the Caltech Campus Executive program.

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November 04, 2003

Neurotechnology Enables More Effective Communication

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Posted by Zack Lynch

As the information technology wave continues its impressive course of capturing and displaying complex information, we are quickly reaching a time where socially filtered, instant information will arrive to each of us in real-time. Recent advances in wearable computers, like glasses that can boost memory by up to 50%, are just one of many innovations to come.

Obtaining information will no longer be our primary constraint as a global civilization. Instead, knowing how, when, why, and for what purpose to use information will be. To be able to absorb, reflect and effectively use instant information, individuals will need to develop new social capabilities.

Social processes like consensus building, value orientation and developmental conversations will require professionals to help individuals live and work in an always-on, always-available world. This will create a tremendous need for social facilitators (today's teachers, managers, psychologists, and psychiatrists are some examples) to help people learn the social interaction skills needed to live and work productively.

Emotional efficiency will become a primary focus in this new era. With 5 of the 10 leading causes of disability being mental problems, there is plenty of space for improvement. Neurotechnology will play an important role in defining mental illnesses while neuroceuticals will be part of the toolset that people use compete in an ever more emotional acute world.

After all, the end game is not just better information, but communication that is relevantly directed, truthfully understood and consciously co-created.

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October 29, 2003

Finance with Feelings

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Posted by Zack Lynch

In Second that Emotion, economic commentator James Glassman discusses how several mutual funds are using techniques pioneered by behavioral economists to help take into account emotions in financial markets.

Behavioral economists have shown that, under some circumstances, people aren't rational actors in their economic decision-making; they are influenced heavily by their emotions. So as Glassman put it, "How do you fight emotional, irrational responses to financial stimuli?"

One answer he gives is "mean reversion." But with emerging neurotechnology the answer could be quite different. For instance, traders could be given emotional forecasting feedback and neuroceutical tools to adjust their perception of future events.

Here is a simplistic thought experiment on how neurotechnology might play a role:

1. Reduce overestimation with real-time impact bias feedback: The gap between what we predict and what we ultimately experience is the ''impact bias'' -- ''impact'' meaning the errors we make in estimating both the intensity and duration of our emotions and ''bias'' our tendency to err.

To predict correctly how they will feel about their decision some time after it occurs, people need to know: the acceleration of their initial emotional reaction, the peak level of intensity of their reaction and the rate of deceleration. People almost always overestimate the rate of acceleration, overestimate the peak level of intensity and underestimate the rate of deceleration of the pleasure that their decisions gave them.

As George Lowenstein, an expert in emotional forecasting points out, ''If you had a deep understanding of the impact bias and you acted on it...you would tend to invest your resources in the things that would make you happy." In short, financial traders would perhaps make decisions that were more in-line with longer-term satisfaction and financial returns.

2. Reduce empathy gap by stabilizing emotional states: The "empathy gap" is the difference between how we behave in "hot'' states (those of anxiety, courage, fear, and the like) and ''cold'' states of rational calm. Our empathy gap impacts our thoughts and behaviors to the point where we cannot seem to predict how we will behave in a hot state when we are in a cold state.

Emoticeuticals that would be triggered when a trader was in a particular "hot" state that could remind them of the consequences of making a trade when they are in a particular state. The baseline for the trigger might be a complex of multiple "hot" states that the trader would determine was most appropriate for them based on their trading history and when they have made poor decisions.

Clearly the above example is simplistic. It is a thought experiment on how financial trading might be impacted by neurotechnology. More to follow.

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September 10, 2003

Forecasting Happiness

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Posted by Zack Lynch

Do people really know what will make them happy?  Not really, according Danny Kanheman, who shared the 2002 Nobel prize in Economics with Vernon Smith.


While we know a Rolling Stones concert beats a trip to the dentist, we almost always overestimate the intensity and the duration of our emotional reactions -- our affect --  to future events.  Although we might believe a new BMW will make life much better, it will likely be less exciting than anticipated and it will not excite us for as long as we thought.


Over the past few years, a group of experimental economists have begun to question the decision-making process that shapes our sense of well-being: how do we predict what will make us happy or unhappy -- and then how do we feel after the actual experience? For example, how do we suppose we'll feel if our favorite college basketball team wins or loses, and then how do we really feel a few days after the game?


Here are a few excerpts from "The Futile Pursuit of Happiness" which is a conversation with the leading figures in "affective forecasting". I highly recommend it.



Daniel Gilbert, Professor os psychology at Harvard, calls the gap between what we predict and what we ultimately experience the ''impact bias'' -- ''impact'' meaning the errors we make in estimating both the intensity and duration of our emotions and ''bias'' our tendency to err. The phrase characterizes how we experience the dimming excitement over not just a BMW but also over any object or event that we presume will make us happy. Would a 20 percent raise or winning the lottery result in a contented life?  You may predict it will, but almost surely it won't turn out that way. And a new plasma television? Worse, Gilbert has noted that these mistakes of expectation can lead directly to mistakes in choosing what we think will give us pleasure. He calls this ''miswanting.''


George Loewenstein then explains: ''Happiness is a signal that our brains use to motivate us to do certain things. And in the same way that our eye adapts to different levels of illumination, we're designed to kind of go back to the happiness set point. Our brains are not trying to be happy. Our brains are trying to regulate us.'' 


Then he goes on to describe the "empathy gap", the difference between how we behave in "hot'' states (those of anxiety, courage, fear, drug craving, sexual excitation and the like) and ''cold'' states of rational calm. This empathy gap in thought and behavior -- we cannot seem to predict how we will behave in a hot state when we are in a cold state...''These kinds of states have the ability to change us so profoundly that we're more different from ourselves in different states than we are from another person.''


Tim Wilson says: ''We don't realize how quickly we will adapt to a pleasurable event and make it the backdrop of our lives. When any event occurs to us, we make it ordinary. And through becoming ordinary, we lose our pleasure.''


Kahneman, who did some of the first experiments in the area in the early 1990's, affective forecasting could greatly influence retirement planning, for example, where mistakes in prediction (how much we save, how much we spend how we choose a community we think we'll enjoy can prove irreversible. He sees a role for affective forecasting in consumer spending, where a ''cooling off'' period might remedy buyer's remorse. Most important, he sees vital applications in health care, especially when it comes to informed consent.


To Loewenstein... a life without forecasting errors would most likely be a better, happier life. ''If you had a deep understanding of the impact bias and you acted on it, which is not always that easy to do, you would tend to invest your resources in the things that would make you happy,'' he says. This might mean taking more time with friends instead of more time for making money. He also adds that a better understanding of the empathy gap -- those hot and cold states we all find ourselves in on frequent occasions -- could save people from making regrettable decisions in moments of courage or craving.


''You know, the Stones said, 'You can't always get what you want,' '' Gilbert adds. ''I don't think that's the problem. The problem is you can't always know what you want.'' 


The implications of this research are profound.  Indeed, neuroceuticals are the tools that will help ordinary people reduce their "empathy gap" and gain control over their "impact bias".

Update 080804: Marginal Revolution on Economics and Happiness

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