: the markets are composed of boundedly rational agents(individuals driven somewhat by psychology), they have states of dise-quilibrium (prices are unstable even without new information), and theyexhibit “fat-tailed” price change distributions (large price changes occurmuch more frequently than expected by chance).
As Mauboussin points out, the stock market has no deﬁned outcomeand no deﬁned time horizon. Prices in the ﬁnancial markets both informand inﬂuence participants about the future. Diversity (or efﬁciency) is lostin the markets when investors imitate one another or when they rely onthe same “information cascades.” Information cascades induce market par-ticipants to make the same decisions based on the same signals from theenvironment, without consideration that others are doing likewise.
From Mauboussin’s work one can draw several conclusions. In orderto ﬁnd advantages in the markets, one must search for “diversity break-downs.” Diversity breakdowns represent collective overreactions or under-reactions to new information, often leading to mispricings that ultimatelycorrect themselves. Investment proﬁts can be made both as the mispricingsform and as they break down.
When researchers ﬁnd brain activation patterns leading to uniformbuying or selling during market experiments, then they may have located aplausible brain mechanism for diversity breakdowns. As Mauboussin putsit, “So the issue is not whether individuals are irrational (they are) butwhether they are irrational in the same way at the same time.” He goeson, “While understanding individual behavioral pitfalls may improve yourown decision making, appreciation of the dynamics of the collective is thekey to outperforming the market.”23
Diversity breakdowns may sound like a rare event, but in fact theyoccur every day in the ﬁnancial markets. Because we are biological be-ings with common biological hardware, we are susceptible to common
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inﬂuences from the environment. Environmental factors that sway collec-tive thinking can be overt (such as news releases) or beneath awareness.Natural cycles (such as variations in daylight) and meteorological events(such as cloud cover and geomagnetic storms) alter collective mood andbehavior. These group-level shifts in emotion and thought have been shownto affect market price movements.
METEOROLOGICAL ANOMALIES AND OTHERANIMAL SPIRITS
Calendar and meteorological effects are surprising both for the size oftheir impact on market prices and for the fact that they operate entirelybeneath awareness. Short-term natural inﬂuences on investing behaviorarise from six areas: Daily sunshine versus cloud cover, disruptions in sleeppatterns, temperature extremes, lunar cycles, electromagnetic storms, andwind strength. A long-term biological inﬂuence on investor behavior is thegradual waxing and waning of daylight as seasons change.
Professor Hirshleifer at Ohio State University found that morning sun-shine correlates with stock returns.24 He examined 26 stock market indicesaround the globe for the period of 1982 to 1997. He looked at sunshine ver-sus some cloud cover in the city of a nation’s largest stock exchange. “InNew York City, the annualized nominal market return on perfectly sunnydays is approximately 24.8 percent per year versus 8.7 percent per year onperfectly cloudy days.” He cites evidence that sunshine improves investors’moods. When their moods are elevated, investors are less risk averse andare more likely to buy.
Kamstra, Kramer, and Levi (2003) ﬁnd that stock returns are signiﬁ-cantly related to season. They examined stock market performance duringthe six months between the fall equinox (September 21) and the springequinox (March 21) for the northern hemisphere and the opposite six-month period for the southern hemisphere. The authors found that overall,stock markets underperformed in the seasonal summer and outperformedin the winter. As an example, the authors cite the returns of a portfolio in-vested 50 percent in each of Sydney, Australia (the most southerly majormarket with the most daylight during the northern winter) and Stockholm,Sweden (the most northerly major market with the most daylight duringthe summer). From 1982 to 2001 this equal-weighted portfolio earned 13.1percent annually. If the entire investment followed the darkness acrosshemispheres, investing in Stockholm from September to March and Sydneyfrom March to September, the annual returns were 21.1 percent (versus 5.2percent if doing the opposite strategy). The researchers hypothesized that
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emotional shifts, related to the biology underlying seasonal affective disor-der (SAD), alter risk preferences and subsequent investment behavior on acollective level.25
Goetzmann and Zhu (2002) analyzed trading accounts of 79,995 in-vestors from 1991 to 1996, and they found that individual investors donot trade differently on sunny days versus cloudy days. However, the au-thors found that market-maker behavior was signiﬁcantly impacted by thedegree of cloud cover: Wider bid/ask spreads on cloudy days were hypoth-esized to represent risk aversion among market makers. Other researchersdiscovered that morning cloud cover and wind speed in Chicago corre-late with wider bid-ask spreads in the afternoon.26 The weather in the ex-change’s home city affects market-maker behavior, but investors in othercities who place orders on the exchange are probably unaffected.
While it seems plausible that sunlight affects investor moods andtrading behavior, some much more extraordinary correlations have beenfound. Researchers found that severe geomagnetic storms (a result of so-lar ﬂares) caused world stock market underperformance over the six daysfollowing the event.27 Interestingly, the psychology literature demonstratesa correlation between geomagnetic storms and signs of depression in thegeneral population during the two weeks following. Depression is an emo-tional disorder characterized, in part, by risk aversion.
In addition to sunshine and geomagnetic storms, researchers foundthat poor sleep quality leads to subpar market returns. Daylight savingstime serves as a proxy for sleep disruption (desynchronosis). Kamstra,Kramer, and Levi (2002) found that on the time-change weekends of day-light savings time there are below normal stock returns from the Fridaymarket close to the Monday open (two to ﬁve times larger than normal).The authors hypothesize that this underperformance is due to impairedjudgment secondary to sleep disruption. Expanding this hypothesis, theaverage weekend desynchronosis may explain the “Monday effect,” whereprices rise less on average on Mondays than on other days of the week.
Other environmental variables affect investors as well. Cao and Wei(2002) found that abnormal local temperatures affect stock prices in thecity of a country’s major stock exchange. The authors draw on psychologystudies showing increased physical activity in unusually low-temperatureenvironments and increased apathy and aggression during period of abnor-mally high temperatures.
Yuan, Zheng, and Zhu (2001) ﬁnd a lunar effect on stock prices world-wide. The authors report that stock market returns in 48 countries arelower during the days surrounding a full moon than during the days arounda new moon. The superior returns around the new moon amount to 6.6 per-cent annually.28 In fact, the light of the full moon may contribute to more
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frequent nocturnal awakenings, sleep disruption, and subsequent next-dayrisk aversion.
These natural market anomalies tell a compelling story about theimpact of the natural world on collective investor behavior and marketprices. Seasonal and meteorological factors may contribute to market priceanomalies via collective changes in emotional states (and thus risk prefer-ences). These ﬁndings indicate that investors’ mood states are the basis ofsome of the predictable volatility in the markets. Importantly, such mar-ket patterns are predictable and signiﬁcant, and result from unconsciouschanges in collective behavior.
SENTIMENT
If investors’ emotional states can predict market price movements, is therea way of measuring investors’ average emotion in advance to predict mar-ket prices? Of course, the above authors measured environmental stimulisuch as sunlight and magnetism, which are known to inﬂuence mood andbehavior. In the ﬁnance literature, surveys that ask investors how “bullish”or “bearish” they feel are available.
Researchers found that both newsletter writers29 and individualinvestors30 show increased optimism about future stock market gains(bullishness) following high recent returns. Additionally, as the S&P 500declined over a 12-month period, investor optimism about the stock mar-ket’s future declined in tandem with prices.31 Investors’ projections of fu-ture market action reﬂect their feelings about recent price trends.
Perhaps paradoxically, Fisher and Statman (2000) noted that the per-centage of investors who believed the market was overvalued was corre-lated with expectations of future returns from 1998 to 2001.32 That is, eventhough investors knew that the market was “overvalued,” their expecta-tions of future gains actually increased the more they thought it was over-priced. Based on this surprising ﬁnding, it appears that investors’ intellec-tual assessment (“overvalued”) is decoupled from their underlying feelingof optimism (“it’s going up!”). In general, sentiment levels do appear tobe negatively correlated with (and somewhat predictive of) future marketprice changes.33
Across individuals, biological commonalities in information process-ing, such as those generated by emotion, lead to diversity breakdowns inmarket prices. The large and repeating effects of meteorological and cal-endar events on market prices indicates that subtle biological forces in-ﬂuence group investment activity. The dissociation between intellectual
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assessments of market value and sentiment suggests that different brainsystems are mediating decision making. Understanding both the neuralorigins and provocateurs of diversity breakdowns may lead to novel in-vestment strategy development and training programs to eliminate thosebiases.
The next chapter introduces the brain circuits responsible for biased in-vestment behavior.
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C H A P T E R 2
Brain BasicsThe Building Blocks
“In terms of biological design for the basic neuralcircuitry of emotion, what we are born with is whatworked best for the last 50,000 human generations.. . . The slow, deliberate forces of evolution that haveshaped our emotions have done their work over thecourse of a million years; the last 10,000 years have. . . left little imprint on our biological templates foremotional life.”
—Daniel Goleman, Emotional Intelligence1
I nvestors’ emotions and motivations are often unconscious, but they are
nevertheless powerfully inﬂuential over decision making. Fortunately,new tools in psychology and technologies in neuroscience are reveal-ing the deep neural origins of investors’ emotional biases and suggestingtechniques to ameliorate their effects on judgment. The next two chaptersdescribe the neural and mental foundations of ﬁnancial decision making,beginning here with the brain origins.
Some psychiatric disorders manifest through repeatedly poor ﬁnan-cial decision making. Compulsive stealing, hoarding unneeded items,shopping out of control, and making wildly speculative gambles are allcharacteristics of different types of mental illness. When I was training asa psychiatrist, we occasionally evaluated patients who had no known neu-rological, addictive, or mental disorder but who nonetheless demonstratedchronically poor ﬁnancial judgment.
At San Francisco General Hospital, the psychiatry consultation teamwas called to assess the decision-making capacity of a patient named Lee.
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One year earlier, after months of increasing headaches, visual abnormali-ties, and difﬁculty concentrating, a tumor had been detected in Lee’s brain.Lee was 53 years old and a partner in an accounting ﬁrm at the time. Hewas suffering from a rare, benign tumor of the brain called a meningioma.These tumors arise in the meninges, the thin but dense membrane that sep-arates the brain from the skull. In Lee’s case, the tumor had swelled upwardfrom the base of his skull, displacing the brain tissue along the midline ofhis frontal lobes. It was the size of a lemon by the time it was discovered.
Neurosurgery was performed and successfully led to the tumor’s re-moval. As in many cases like this, some normal brain tissue had beenstarved of oxygen by the tumor, and the dead tissue was also removed fromthe brain. As a result, Lee lost part of his brain’s orbitofrontal cortex (OFC).A few weeks after surgery, Lee returned home from the hospital andtried to go back to life as usual. Even though he had lost part of his brain,Lee was still an intelligent man. His IQ remained superior, and his neu-ropsychological testing showed no signiﬁcant motor, perceptual, visuospa-tial, or calculation deﬁcits.
However, according to his wife, he demonstrated some unusual behav-ior during his ﬁrst two months at home. He made a few large, unnecessarypurchases on his credit card, including two new cars and a boat. His wifeasked him to stop making such purchases, as they already had what theyneeded. He was agreeable to this request, and returned one of the carsand the boat. Yet he continued to make large purchases at an alarmingrate, quickly maxing out his credit card limits and further distressing hiswife.
His performance at work was characterized by an inability to mul-titask. He often became totally involved in doing one activity all dayeven though many others urgently needed his attention. His performancedropped off, and over six months it became clear that he couldn’t con-tinue to manage his current projects. He left his workplace, taking earlyretirement.
After retirement, he continued to make bad investment decisions. Hebought several vacation time-shares with little money down, encouragedby slick sales pitches. He bought penny stocks based on fax and e-mailpromotions. He lost large sums of money in most of these investments.After several months, he could no longer afford his mortgage payments.He and his wife were on the brink of bankruptcy and divorce.
We were seeing Lee one year after his surgery. As psychiatrists, it wasour job to determine if Lee was still competent to manage his own medical,legal, and ﬁnancial decisions. If not competent, some of these decisionscould be taken over by his wife.
Lee was intellectually aware that he had been making very riskyinvestments with his limited resources. He acknowledged that this was
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completely new behavior for him. Previously, he had been a conservativeinvestor, and he didn’t like to gamble. Now he knew how he should feelabout the ﬁnancial risks he was taking, but he didn’t feel afraid. In fact,he didn’t feel much of anything about risk. He didn’t restrain himself fromtaking large speculative risks because the investments didn’t feel risky tohim.
Our team determined that Lee was normal in every way except in hisassessment of risk. He was not inhibited by fear, and he was easily enticedby potential opportunity. Lee’s situation illustrates that risky decisionmaking is rooted in somewhat fragile neurological processes. Most peopleare occasionally tempted to invest in speculative ventures or to purchaseprohibitively expensive luxury goods, but they exercise self-restraint dueto the potentially negative consequences of excessive debt. Because theyare afraid of the consequences, they refrain from indulgence. Duringbackground research we realized that Lee was experiencing similarimpairments to a group of patients studied extensively by neurologistAntonio Damasio at the University of Iowa.
DAMASIO AND THE IOWA GAMBLING TASK
Lee had a lesion in the OFC of his brain. Damage in other areas of Lee’sbrain could have led to similar problems as he was experiencing if it hadaffected the broad brain circuit, part of which was removed from Lee’sOFC, called the “loss avoidance system.” When a brain tumor or other eventleads to damage in part of the loss avoidance system (such as the OFC,depicted in Figure 2.2 on page 24), how individuals perceive and processrisky situations is altered.
In the early 1990s, then at the University of Iowa, the neurologistAntonio Damasio took an interest in several patients with OFC lesions inhis neurology clinics. His patient group had lesions of the ventromedialprefrontal cortex (the midline aspect of the OFC). Like Lee at my hospital,these patients retained their basic intelligence, memory, and capabilitiesfor analytical reasoning and for logical thought,2 but they made poordecisions in risky situations.
Many of these patients reported that they knew when they should feelafraid, but they had difﬁculty both (1) experiencing emotions and (2) asso-ciating their feelings with anticipated consequences. Essentially, they hada deﬁcit in their ability to integrate emotions and thinking.
It turns out that the part of the brain these patients were miss-ing, the OFC, evaluates the relevance of emotional input to one’s deci-sion making.3 Damasio’s patients could not understand what emotional
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“Bad” decks
“Good” decks
A
B
C
D
Gain per card
$100
$100
$50
$50
Loss per 10 cards
$1250
$1250
$250
$250
Net per 10 cards
–$250
–$250
+$250
+$250
FIGURE 2.1 The Iowa Gambling Task. Notice that the net return per deck is neg-ative for decks A and B and positive for decks C and D. Additionally, the range ofgains and losses is much smaller in decks C and D.
information was important. Just like Lee, they knew when they should beafraid, but they could not use fear to help them avoid taking a dangerousﬁnancial risk.
Damasio wanted an instrument to detect his patients’ problem withrisk processing. He designed a card-playing game, called the Iowa Gam-bling Task, to measure physiological and behavioral responses to risk inthese patients. The participants were connected to electrophysiologicalarousal monitoring devices (as in lie-detector tests) such as a skin con-ductance response (SCR) monitor. In the task, four decks of cards werelaid out in front of brain-lesioned patients and normal controls.4 The sub-jects then selected cards from any of the four decks with the overall goalof maximizing their ﬁnancial gain. See Figure 2.1 for a depiction of the carddecks, outcomes, and odds for each deck.
Subjects were not told the overall odds or payoffs of the card decks.They were simply told to play the game and to try to make as much moneyas possible. The two decks on the left, “A” and “B,” yielded either cardsvalued at $100 or −$1,250. The two decks on the right yielded cards valuedeither $50 or −$250. The expected value of each card in decks A and B was−$250 while for decks C and D it was $250.
Damasio found that the patient group was more likely to choose cardsfrom decks A and B (the “bad” decks). The patients did not generate an-ticipatory SCRs to the risky decks (A and B), and they played deﬁcientlyoverall. “Even after several of them realized which decks were bad, theystill made the wrong choices.”5 Without the ability to integrate emotionand reason in the OFC, the patients’ danger assessment of the “bad” decks
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was intellectually intact, but it did not alter their decision making, and theycontinued to choose cards from the losing decks.6
Unlike the brain-damaged patients, normal subjects learned to avoidthe losing decks. After ﬂipping the ﬁrst 10 cards, normals began to showphysiological “stress” reactions on the SCR measurements when hoveringover decks A or B. Patients never showed such responses. Furthermore,even though the normal subjects experienced a physiological stress reac-tion after 10 card ﬂips, they could not consciously identify that decks Aand B were the money-losing decks until over 40 card ﬂips later. Normalsbegan to ﬂip more cards from the “good” decks C and D before they wereconsciously aware that these decks were “good.” That is, normal peoplehad “gut” stress reactions to the losing decks after 10 ﬂips, and changedtheir behavior to prefer decks C and D. Yet they only articulated a “hunch”which were the losing decks after 50 card ﬂips. They could explain theirhunch with certainty only after 80 ﬂips.
Damasio’s research implies that people need feelings to signal when toavoid losses in risky environments. When making risky decisions, there isa gap between what the emotional brain (the limbic system) knows aboutrisk and one’s conscious awareness of the actual danger. Intuitive deci-sions, where “gut feel” drives judgment, arise from such limbic knowledgeand are discussed in Chapter 5. In the brain-damaged gamblers, a brainregion that integrates risk-related feelings with reasoned decision makinghad been taken off-line.
THE BRAIN: STRUCTURE AND FUNCTION
In order to gain insight into the brain-lesioned patients’ deﬁciency in riskprocessing, it’s useful to pause for a basic tutorial on how the brain oper-ates. The human brain is the product of millions of years of evolution, andit is designed to efﬁciently and effectively interpret information, competein a social hierarchy, and direct activity toward achieving goals whileavoiding danger. However, our brains evolved in a stone-age world wheredangers and opportunities were largely immediate, and social interactionswere limited to other members of the clan. Now, as the modern worldbecomes more interconnected and fast paced, it is apparent that thestone-age brain is not optimized for managing the complexities of modernlife.
In a generalization that will be repeated throughout this book, thebrain can be conceptualized as having three anatomical divisions. Eachdivision is like the layer of an onion, with complex processes such as an-alytical decision making in the outer layer, motivations and drives arising
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from the middle layer, and life-sustaining physiological processes originat-ing in the innermost core. This conceptual schema is termed the “Triune”brain.7
The cortex is the brain’s logistical center. It is the director of executivefunction and motor control. The part of the cortex called the prefrontal cor-tex is of most interest to this discussion. The prefrontal cortex is involvedin abstract thinking, planning, calculation, learning, and strategic decisionmaking.8 Another part of the cortex, called the insular cortex, is evolution-arily distinct from the neocortex. In this book, when using the word cortex,I am broadly referring to the neocortex and the prefrontal cortex, but ex-cluding the insular cortex.
The brain’s limbic system is the emotional driver of the brain. The lim-bic system is the source of primitive motivations and emotions includingfear and excitement. Both the cortex and the limbic system are displayedin Figure 2.2. The third division of the brain is called the midbrain (a.k.a.“the reptilian brain”). The midbrain manages the body’s basic physiological
PREFRONTALCORTEX
PARIETALCORTEX
ORBITOFRONTALCORTEX
FIGURE 2.2 A depiction of the whole brain. The limbic system is seen situated un-derneath the cortex. The prefrontal cortex lies behind the forehead. The orbitofrontalcortex (OFC) is located behind the eyes and above the sinuses. The parietal cortexis situated at the posterior of the brain.
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processes, including respiration and heart rate, and it will not be discussedfurther in this book.
Running across the three brain divisions are neural circuits that op-erate two types of goal-directed behavior: (1) reward pursuit and (2) lossavoidance.9 The existence of reward approach and loss avoidance systemshas been hypothesized since the time of Aristotle in ancient Greece.10 Priorto the late twentieth century, both the reward and the loss systems werethought to drive organisms toward pleasure and away from pain. Currently,scientists believe that these systems encompass complex brain processesinvolving emotions, cognitions (thoughts), and actions. While the rewardand loss systems are largely independent, when one system is highly acti-vated, it may trigger a reciprocal deactivation of the other.
First, I will describe the reward system. Objectives we want to achieveand items we want to possess are called “rewards,” and the pursuit of suchrewards is headquartered in the brain’s “reward system.” The reward sys-tem is involved in scanning the environment for, evaluating, and attemptingto procure desired gains (rewards).
The reward system is comprised of neurons that predominantly com-municate via the neurotransmitter dopamine. Dopamine has been calledthe “pleasure” chemical of the brain, because people who are electricallystimulated in the reward system report intense feelings of well-being.11 Il-licit drug use causes dopamine release in the nucleus accumbens (partof the reward system), which is why street drugs are colloquially called“dope.” The reward system coordinates the search for, evaluation of, andmotivated pursuit of potential rewards. See Figure 2.3 for a depiction of thereward system.
The motivational systems allow us to quickly assess and value po-tential opportunities and threats in the environment. When we perceivesomething valuable, our reward system is activated, and we desire it. Manyitems and goals are valuable to us. We value pleasant tastes (especiallyfatty, sweet, and salty foods).12 We value sex appeal13 and generosity14 inothers. We value status symbols (such as luxury goods and sports cars15).We value laughing16 and loved ones, and we value revenge and the pun-ishment of deviants.17 These valued events all activate the brain’s rewardsystem.
A second motivational circuit governs “loss avoidance.” The “lossavoidance system” is activated when we become aware of threats or dan-gers in our environment. Anxiety, fear, and panic are emotions that arisefrom the loss avoidance system, and pessimistic and worried thoughts arethe cognitive sequelae of loss system activation.
The anatomy of the brain’s loss system is less well deﬁned than thatof the reward system. The loss system is thought to consist of the ante-rior insula (pain and disgust), the amygdala (emotional processing), the
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FIGURE 2.3 The brain’s reward system. A bundle of dopamine neurons in themidbrain sends projections throughout the prefrontal cortex.
hippocampus (memory center), and the hypothalamus (hormone secretingcenter). See Figure 2.4.
Loss system activation affects the entire body through bloodstreamhormone and neurotransmitter release. The perception of a threat activatesthe hypothalamus-pituitary-adrenal axis (HPA axis), which results in stresshormone and epinephrine (“adrenaline”) secretion into the bloodstream.The body’s sympathetic nervous system (SNS) prepares the whole bodyfor the “ﬁght-or-ﬂight” response to danger with nerve signals transmittedto every major organ system. When under threat and experiencing fear,signs of SNS activation include trembling, perspiration, rapid heart rate,shallow breathing, and pupillary dilation. The SNS is also responsible forthe physical signs and symptoms of panic.
Because the reward and loss systems inﬂuence thought and lie be-neath awareness, they often direct behavior automatically through subtleemotional inﬂuences on judgment, thinking, and behavior. In Damasio’spatients, the interface between fearful feelings generated by the loss
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FIGURE 2.4 An illustration of several components of the brain’s loss avoidancesystem.
avoidance system and reasonable thought generated by the prefrontalcortex was interrupted. Fortunately, investigators have a number of toolsfor assessing the health of the brain’s reward and loss avoidance systems.
THE BRAIN-DAMAGED INVESTOR
According to a 2005 Wall Street Journal article, “Lessons from the Brain-Damaged Investor,” brain-damaged traders may have an advantage in the
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markets.18 Study