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Extraversion. Characterized by a desire to socialize, gregariousness, anda tendency to optimism.
Fear. Deﬁned as an unpleasant, often strong emotion caused by anticipa-tion or awareness of danger.
Feelings. Conscious experiences that help in the identiﬁcation of emo-tions. When one feels afraid, one can identify the emotion of fear. Not allfeelings are emotions, but all (conscious) emotional experiences are feel-ings.
Frontal cortex. The portion of the brain involved with reasoning, plan-ning, abstract thought and other complex cognitive functions in additionto motor function.
Functional magnetic resonance imaging (fMRI). Allows researchersto measure changes in brain activity over short time intervals (two sec-onds) in small regions of the brain (two cubic millimeters). Changesin brain activity are indicated by alterations in regional metabolism,tissue oxygen usage, and blood ﬂow (blood-oxygen level dependentsignal—BOLD).
Fundamental analysis. The use of corporate statistics—including man-agement efﬁcacy, earnings, asset value, and debt—to forecast future stockreturns.
Futures contract. A dervivative that gives the owner the right topurchase a commodity or equity at a future date at a predeterminedprice.
Goal. The purpose toward which an endeavor is directed; an objective.
Greed. Excessive desire to acquire or possess more (especially more ma-terial wealth) than one needs.
Glucocorticoids. A class of steroid homones secreted during stress. Theyinclude cortisol (a stress hormone).
Herding. When many investors make the same choice based on the obser-vations of others, independent of their own knowledge.
Hippocampus. A brain region within the limbic system that plays a centralrole in learning and memory.
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Hope. The general feeling that some desire will be fulﬁlled.
Hormones. Chemical messengers dispersed by the blood that act on tar-get organs. Main organs involved in hormone production are the pituitary,pancreas, ovary, testes, thyroid, and adrenal. Hormones have an effect onphysiological functioning and psychological behavior.
Hubris. The lack of preparedness and attentiveness to risks that followssuccess in a venture. Hubris often precedes losses.
Hypothalamic-pituitary-adrenal (HPA) axis. A major part of the neu-roendocrine system that controls reactions to stress. It is the mechanismfor a set of interactions among glands, hormones and parts of the midbrainthat mediate a general adaptation syndrome.
Illusion of control. The belief that one can inﬂuence a chance outcome.Occurs when lots of choices are available, you have early success at thetask (as in the coin-ﬂipping example above), the task you are undertakingis familiar to you, the amount of information available is high, and you havepersonal involvement.
Implied volatility. In options contracts, a ﬁgure derived from the marketprice of an option. Implied volatility can be thought of as a measure of therisk of an instrument or portfolio right now, as opposed to in some periodin the past (historic volatility).
Impulse-control (impulsivity). The ability to manage one’s urges,caprices, and sudden desires.
Investor. One who owns shares of a company or asset, typically with theexpectation that the proﬁts of the business or the value of the asset willincrease over time.
Investment. The use of money for the purpose of making more money, togain income or increase capital, or both, usually through the purchase of asecurity or asset.
Jones, Paul Tudor. Born in 1954 in Memphis, Tennessee; a well-knowncommodity trader. Having made $500 million in 2005, he is worth anestimated $2.5 billion, and was ranked by Forbes in September 2006 as the117th richest person in the world.
Judgment. The cognitive process of reaching a decision or drawing con-clusions.
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Kahneman, Daniel. Born 1934 in Tel Aviv, Israel; a key pioneer and the-orist of behavioral ﬁnance, which integrates economics and cognitive sci-ence to explain seemingly irrational risk management behavior in humans.
Knutson, Brian. Associate professor of psychology at Stanford Universityand director of the SPAN lab. His long-term research goal is to understandthe neurochemical and neuroanatomical mechanisms responsible for emo-tional experience.
Kuhnen, Camelia. An assistant professor at the Kellogg School of Man-agement at Northwestern University. Formerly a PhD student in ﬁnanceat Stanford University and designer of neuroimaging experiments and theBehavioral Investment Allocation Strategy (BIAS) task.
Limbic system. A deep, evolutionarily older system of brain circuits andstructures involved in emotion. Major subsections include the reward sys-tem (nucleus accumbens), the loss avoidance system (amygdala), hor-monal control (the hypothalamus), and memory centers (the hippocam-pus).
Long-Term Capital Management (LTCM). Founded in 1994, this hedgefund boasted two Nobel Prize winners and several of Salomon Brotherstop traders as principals. The fund’s launch was the largest in history up tothat time: $1.25 billion. While LTCM’s fees were above the industry average(taking 25 percent of net returns), the proﬁts over the fund’s ﬁrst four yearswere large, seeming to justify the high fees. By April 1998, $1 invested inthe fund at its inception in 1994 was worth $2.85 (after fees). Due to highlyleveraged and erroneous bets against volatility, the fund collapsed spectac-ularly in late 1998, endangering the global ﬁnancial system. A bailout wasorganized by the New York Federal Reserve.
Loss aversion. In prospect theory, loss aversion refers to the tendency forpeople to strongly prefer avoiding losses than acquiring gains. Some stud-ies suggest that losses are as much as twice as psychologically powerfulas gains. Loss aversion was ﬁrst theorized by Amos Tversky and DanielKahneman (winner of the 2002 Nobel Prize in economics).
Loss avoidance system. A fundamental motivation system in the brain,geared towards the avoidance of harm and potential danger. Consists ofseveral subcortical structures related to negative emotion processing andresponse, including the amygdala, hippocampus, hypothalamus. Corticalstructures include the insula and the anterior cingulate gyrus.
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Lynch, Peter. Born January 19, 1944; a successful Wall Street investor,and arguably one of the best stock-pickers in the world. He is currently apresident at Fidelity Investments.
Medial prefrontal cortex (MPFC). The gray matter on the medial aspectof the frontal lobes. Thought to be functionally related to liking, trust, andpreference.
Meriwether, John. Born August 10, 1947, in Chicago, Illinois; an Amer-ican ﬁnancial executive on Wall Street seen as a pioneer of ﬁxed incomearbitrage. Meriwether worked as a bond trader at Salomon Brothers wherehe became the head of the domestic ﬁxed income arbitrage group in theearly 1980s and the vice-chairman of the company in 1988. The Long-TermCapital Management hedge fund, founded in 1994 in Greenwich, Connecti-cut, and notoriously collapsed in 1998, was his brainchild.
Momentum investing. A style of investing in which equities that haverecently appreciated in price are purchased, with the presumption that theywill continue to outperform over time. Academic research has identiﬁedthe “momentum effect” in stocks that appreciate over the prior 6 months.These stocks are likely to have market-beating returns over the subsequent6 to 18 months.
Motivated reasoning. Thinking biased to produce preferred conclusions.That is, we think about a problem in such a way as to logically lead to theconclusions we wanted to arrive at in the ﬁrst place.
Neuroeconomics. A ﬁeld of study examining the brain bases of economicdecision making.
Neuroﬁnance. The study and application of neuroscience to investmentactivity.
Neuroplasticity. The general notion that aspects of brain function changeover time. In general, increased use of some neural pathways leads tostrengthening of their connections. Decreased use leads to weakening ofconnectivity.
Neuroticism. Characterized by stress sensitivity and more frequent expe-riences of negative emotions than others.
Neurotransmitter. Chemical messengers released from axon terminalsas a result of an electrical impulse. These chemicals travel across thesynapse and bind to speciﬁc receptors on the postsynaptic side, thus
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changing the electrical excitation and protein expression of the secondneuron. Excitatory neurotransmitters increase the likelihood that the nextneuron will have an action potential, whereas inhibitory neurotransmittersdecrease the likelihood.
Norepinephine (a.k.a. noradrenaline). A neurotransmitter whose func-tions include release from the ends of the ﬁnal neurons in the sympatheticnervous system, as well as a role in depression (with, most likely, a deple-tion occurring).
Nucleus accumbens (NAcc). A nucleus forming the ﬂoor of the caudalpart of the anterior prolongation of the lateral ventricle of the brain. Acti-vated by anticipation of reward and reward pursuit and produces positiveaffect when activated.
Openness (personality). Openness to new experiences describes a di-mension of personality that distinguishes imaginative, creative people fromdown-to-earth, conventional people.
Opiate. A type of depressant drug that diminishes pain and central ner-vous system activity. Prescription opiates include morphine, meperidine(Demerol), methadone, codeine, and various opioid drugs for coughing andpain. Illicit opioids include heroin.
Option. A contract whereby the contract buyer has a right to exercise afeature of the contract (the option) on or before a future date (the exercisedate). The writer (seller) has the obligation to honor the speciﬁed feature ofthe contract. Since the option gives the buyer a right and the seller an obli-gation, the buyer has received something of value. The amount the buyerpays the seller for the option is called the option premium.
Orbital frontal cortex (OFC). The region of association cortex of thehuman brain involved in cognitive processes such as decision making. Thisregion is named based on its location within the frontal lobes, resting abovethe orbits of the eyes.
Overconﬁdence. There are several varieties: one type of overconﬁdenceis the “better than average” effect. Researchers who ask subjects to ratetheir abilities, such as skill in driving, athletic ability, or running a busi-ness, ﬁnd that most people consider themselves better than average. Someindividuals were found to overestimate the precision of their knowledge(miscalibration). Others are overconﬁdent in their belief in control overrandom, independent events—called the “illusion of control.”
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Panic. A sudden terror that dominates thinking and often affects groups ofpeople. An overwhelming feeling of fear and anxiety.
Parietal lobe. One of the four major regions of the cortex. This area dealswith reception of sensory information from the body’s opposite side. It alsoplays a part in reading, writing, language, and calculation.
Personality. The complex of all the attributes—behavioral, temperamen-tal, emotional and mental—that characterize a unique individual.
Positron emission tomography (PET). A brain imaging technique thatmaps active brain areas via an injection of 2-deoxyglucose, which emitspositrons when taken up by actively metabolizing cells.
Predict. The act of foretelling on the basis of observation, experience, orscientiﬁc reason.
Prefrontal cortex. A recently evolved region of the brain that plays acentral role in executive cognitive function, decision making, gratiﬁcationpostponement, attention-shifting, and regulation (often inhibition) of lim-bic system impulses.
Price-to-earnings (P/E) ratio. The price-to-earnings ratio measures theratio of a company’s stock price to its earnings.
Prisoner’s dilemma. A classic game theory scenario. The setup is alongthe following lines: Two inmates have made an escape attempt from prison,which was unsuccessful. On being separately questioned by the warden,the inmates must decide whether to “defect” (a.k.a. rat out, snitch) theirconfederate or “cooperate” and not give the warden any incriminating in-formation. Highest payments go to those who defect when their confed-erate cooperates. Medium payment if both cooperate. Least payoff if onecooperates while the confederate defects.
Psychophysiology. The branch of psychology that is concerned with thephysiological bases of psychological processes. Investigatory methods in-clude measurements of galvanic skin response (GSR), muscle tone, andvital signs such as heart rate, blood pressure, and respiratory rate.
Reward system. The neural circuitry directing desire and motiva-tion. Extends from dopamine nucleitegmental areathrough the nucleus accumbens (NAcc) to the medial prefrontal cortex(MPFC).
in the ventral
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Rumor. A piece of unveriﬁed information of uncertain origin usuallyspread by word of mouth. Unveriﬁed information received from an-other; hearsay. Information, often of uncertain origin and veracity, spreadthroughout a subpopulation.
Security. An equity, derivative, or commodity share or contract.
Self-attribution bias. The tendency to attribute good outcomes to per-sonal skill and bad outcomes to chance.
Self-control. The trait of resolutely managing one’s own impulses, urges,and behavior to to follow a predeﬁned plan or intention.
Self-regulation. Regulation of oneself automatically, via an intentionalexertion of the will to achieve a goal.
Selective serotonin reuptake inhibitors (SSRIs). Drugs such asProzac that block the removal of serotonin from the synapse. Since theintroduction of Prozac, other SSRI medications developed include Paxil,Zoloft, Celexa, and Lexapro. SSRI medicines were found to decreasethe severity of the symptoms of several disorders: depression, anxiety,obsessive-compulsive, post-traumatic stress, and premenstrual dysphoricdisorders, to name a few. Insofar as they lessen the symptoms of depres-sion and anxiety, this implies that these disorders involve a deﬁciency ofserotonin.
Serotonin. A neurotransmitter. When either the concentration of brainserotonin or the one’s sensitivity to brain serotonin change, one’s behav-ior will change. In the 1970s, researchers discovered that people who com-mitted violent suicide had lower levels of brain serotonin than people whodied by other means. Serotonin levels have since been linked to mood dis-orders such as depression and anxiety and obsessive-compulsive disorder.
Somatic. Pertaining to the body.
Soros, George. Born August 12, 1930, in Budapest, Hungary, as SorosGy ¨orgy; an American businessman. He is famous as a currency specula-tor and a philanthropist. Currently, he is the chairman of Soros Fund Man-agement and the Open Society Institute and is also former member of theboard of directors of the Council on Foreign Relations.
Stock market. A general term used to refer to the organized trading ofsecurities through various physical exchanges, electronic platforms, and
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through the over-the-counter market. A “stock exchange” is a speciﬁc formof a stock market, a physical location where stocks and bonds are boughtand sold, such as the New York Stock Exchange, NASDAQ or AmericanStock Exchange.
Stress. A state of mental or emotional strain or suspense.
Sympathetic nervous system. The half of the autonomic (automatic)nervous system associated with arousal and emergency physiological re-sponses.
Synapse. The gap between two neurons, across which neurotransmissionoccurs.
Technical analysis. Also known as “charting”; utilizes quantitative andvisual interpretations of ﬁnancial data to generate forecasts.
Trader. Individuals who buy and sell for their own accounts for short-term proﬁt. Also, an employee of a broker/dealer or ﬁnancial institutionwho specializes in handling purchases and sales of securities for the ﬁrmand/or its clients
Trust. The trait of believing in the honesty and reliability of others
Ultimatum game. An experimental economics game in which two partiesinteract anonymously and only once, so reciprocation is not an issue. Theﬁrst player proposes how to divide a sum of money with the second party. Ifthe second player rejects this division, neither gets anything. If the secondaccepts, the ﬁrst gets their demand and the second gets the rest.
Uncertainty. The state of being unsettled or in doubt. Conditions whereoutcomes and preexisting information are unknown. A mathematical stateof 50 percent probability of a given outcome.
Valence (emotional). A bipolar conception of feeling, in which they lieon a spectrum from positive to negative.
Value (stocks). Stocks whose shares are priced cheaply relative to thevalue of their underlying assets or earnings potential. Three widely usedﬁnancial ratios used to measure value (though there are many others) are:(1) the price-to-book ratio, (2) the price-to-earnings ratio, and (3) the price-to-cash ﬂow ratio.
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Zak, Paul. Founding director, Center for Neuroeconomics Studies atClaremont Graduate University. His current research focuses on how so-cial cognition produces cooperation or conﬂict, decision making under un-certainty, the neural foundation of human capital, and the effect of insti-tutional design on economic development. His previous research into thebiology of trust is cited in this book.
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Index
Acetylcholine, 48, 55–56Adcock, Alison, 265Adderal (amphetamine), 59, 295as treatment for ADHD, 268
Adrenaline, 26, 137Adrenocorticotropic hormoneAdventure Capitalist (Rogers), 164Affect, 38, 72–73Affect heuristic, 38, 72–73, 88, 175Age, sex, and culture, 275–286
age, brain changes with, 279–280Chinese risk takers, 284–285Chinese stock traders, biases
among, 285–286
culture (East and West), 283–284divorcees, ﬁnancial planning for,
278–279
emotional memories, 276–277female brain, the, 277–278male overconﬁdence, 279Seattle Longitudinal Study of Adult
Development, 280–283
Agoraphobia, 122Agreeableness versus self-interest, 158Alcohol, 58, 61–62Alpha, 12Alprazolam (benzodiazepine), 61Alzheimer’s disease, 56, 282Ambiguity and uncertainty, 180
in the markets, 180–182Ambiguity, risk, and reward,
neuroscience of, 182–183
decreased activation of, with SSRI
use, 60and memory, 276sensitivity, 124and unconscious activation of fear,
75
Analysts’ abuse of authority, 237–238Anterior cingulate cortex (ACC), 32,
268
rostral (rACC), 313Anterior insula, 25, 32Antidepressants, 50, 62
to reduce compulsive shopping, 85
Anxiety disorders, 124, 308Anxiety, fear, and nervousness,
119–129
climbing a wall of worry, 121dread in the MRI, 122–123empathy gaps, 125–127in ﬁnancial decision making, 57of hurricanes, risk perceptions, and
opportunity, 128–129investment lessons, 127–128managing fear, 124–125nature versus nurture, 123–124relief from, 126–127
Anxiolytics. See Selective serotonin
reuptake inhibitors (SSRIs)Apolipoprotein E (ApoE) gene, 282Arachidonic acid pathway, 56Arbitrage, limits to, 326–327Ariely, Dan, 133–136, 141, 194
Amphetamines, 51, 58–59, 113, 295
experiment at Massachusetts
time-release, 62
Amygdala, 25, 28, 32, 127, 195, 196
Institute of Technology (MIT),135–136, 220
383
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Asch, Solomon, 231–232, 237Atomoxetine, 114Attention and memory, 261–273attention deﬁcit, 267–268China Prosperity Internet Holdings,
Benzodiazepines, 55, 61, 308Berg, Stacie Zoe, 93Berns, Greg, 190Beta blockers, 62–63, 295, 308BIASed decision making, improving,
270–272
fond memories, 265–266hindsight bias, beating the, 266–267medication for improving, 268–269representative returns, 264–265“terminal illness,” 263–264
Attention bias, 128Attention deﬁcit-hyperactivity disorder
(ADHD), 52–53, 114, 267–268,306
“Attention effect,” 87Attitudes, 79Auster, Martin, 223
Bandura, Albert, 231Barber, Brad, 94Barkley, Charles, 150Bartiromo, Maria, 272Bayes’s theorem, 99Bechara, Antoine, 28Behavioral Corporate Finance
(Shefrin), 241
Behavioral ﬁnance investing, 317–330
arbitrage, limits to, 326–327“buy on the rumor and sell on thenews” (BRSN), 325–326fund performance, 327–328momentum, size, and the optimal
portfolio, 322products, 328–329risk premia
and expectations, 319–321harvesting, 318–319
value versus glamour, 321–322Behavioral Investment Allocation
Strategy (BIAS) task, 97–100,189–190Behavioral therapy, 57Beliefs and expectations, 42–43Benartzi, Shlomo, 328Bennett, Bill, 150
103–104Bipolar disorder, 55, 59Blodgett, Henry, 236Boesky, Ivan, 96Bogle, John, 10Bonds, Barry, 58Brain basics, 19–33
brain-damaged investor, 27–30Damasio and the Iowa Gambling
Task, 21–23
neuroscience preview, 31–33research methods, 30–31structure and function, 23–27
cortex, 24limbic system, 24loss avoidance system, 25–27midbrain, 24–25reward system, 25, 26
Breiter, Hans, 149Brorson, Jon, 131“Bubble Act,” 3Buffett, Warren, 105, 128, 153, 197, 289Bupropion (Zyban, Wellbutrin), 52, 57
in controlling gambling behavior, 151
Burnham, Terry, 222“Buy on the rumor and sell on the
news” (BRSN), 325–326
Caffeine, 54–55, 58Campbell, John, 253Catechol-O-methyltransferase (COMT)
gene, 160Caudate nucleus, 258Center for Decision Research, 81CEO disease, 108Certainty effect, 177Change techniques, 301–315
cognitive-behavioral therapy andstress management, 304–305fearful and overconﬁdent clients,
dealing with, 302–303
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growing happier, 311–312“learning goals,” maintaining,
314–315
modeling others, 311neurofeedback, 312–314slump, getting out of a, 308–309stress reduction, simple, 307–308trading coaches, 309–311Cymbalista, Flavia, 310Shull, Denise, 310–311
yoga, meditation, and lifestyle, 306
Charting and data mining, 243–260
chart reading, trend and
mean-reversion biases in,247–250
data mining and self-deception,
245–246
earnings reports, patterns in, 259gambler’s fallacy, 253irrational exuberance, 253–255neural networks, artiﬁcial, 244–245randomness, 259–260Soochow Gambling Task (SGT),
255–258Chemical impulses, 219Chemical stabilizers, 294–295Chen, Keith, 205Chicago Board of Trade (CBOT),
196–197, 206
Chicago Mercantile Exchange (CME),
196
China Prosperity Internet Holdings,
270–272
Cialdini, Robert, 229, 236Clemens, Samuel (Mark Twain), xii, 1
and the “silver fever,” 3–5Cocaine, 51, 62–63, 113, 295Cognitive-behavioral therapy (CBT),
127, 304–305Cohen, Abby Joseph, 236Cohen, Steve A., 167Comparator, 38
expectations and, 39–40
Conﬁdence, 115–117Conﬁrmation bias, 44, 182Conscientiousness versus
impulsiveness, 157–158
Cook, Mark D., 296Cooperation, neuroscience of,
236–237
Cortex (brain), 24Cortisol, 53, 137, 138Cramer, Jim, 119–120, 125, 133, 213Culture. See Age, sex, and cultureCurrency trading, short-term, 10
Daly, John, 151Damasio, Antonio, 21–23, 26–27, 255Das, Sanjiv, 233Data mining. See Charting and data
miningDay trading, 9–10, 108deCharms, Christopher, 313Decision journal, creating a, 297–299Decisions, making, 171–187
ambigu