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Sunday, September 22, 2013

Bubbles are All in Your Head

Noah Smith, in a tweet, seemed to think this research is important:

Drivers of financial boom and bust may be all in the mind, study finds, EurekAlert: Market bubbles that lead to financial crashes may be self-made because of instinctive biological mechanisms in traders' brains that lead them to try and predict how others behave...
The research offers the first insight into the processes in the brain that underpin financial decisions and behavior leading to the formation of market bubbles. ... Although bubbles have been intensely investigated in economics, the reasons why they arise and crash are not well understood and we know little about the biology of financial decision behavior.
Researchers at the California Institute of Technology ... found that the formation of bubbles was linked to increased activity in an area of the brain that processes value judgments. People who had greater brain activity in this area were more likely to ride the bubble and lose money by paying more for an asset than its fundamental worth.
In bubble markets, they also found a strong correlation between activity in the value processing part of the brain and another area that is responsible for computing social signals to infer the intentions of other people and predict their behaviour.
Dr Benedetto De Martino, a researcher at Royal Holloway University of London who led the study while at the California Institute of Technology, said: "We find that in a bubble situation, people ... shift the brain processes they're using to make financial decisions. They start trying to imagine how the other traders will behave and this leads them to modify their judgment of how valuable the asset is. They become less driven by explicit information, like actual prices, and more focused on how they imagine the market will change. ...
Professor Peter Bossaerts from the University of Utah, a co-author of the study, explains: "It's group illusion. When participants see inconsistency in the rate of transactions, they think that there are people who know better operating in the marketplace and they make a game out of it. In reality, however, there is nothing to be gained because nobody knows better." ...
The findings give the first glimpse to the decision-making mechanisms in the brain that drive financial markets. Although they may not help to predict the onset of a bubble, the research could help to design better social and financial interventions to avoid the formation of future bubbles in financial markets.

    Posted by on Sunday, September 22, 2013 at 11:20 AM in Economics, Financial System | Permalink  Comments (29)

          


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