April 08, 2008
Sex in the City (of London)
A recent experiment in neuroscience found that young men made bad financial decisions when thinking about sex - who would ever have believed that? The implications of the study for risk management are intriguing.
The wonderfully titled paper 'Nucleus accumbens activation mediates the influence of reward cues on financial risk taking' published in NeuroReport March 2008, is destined to become one of the most often cited papers in Behavioral Finance with an early hint of a future Nobel Prize in Economics.
In a novel experiment using Magnetic Resonance Imaging (MRI) of the brain, neuroscientists from Northwestern and Stanford universities attached 15 'young men' to a brain scanner while testing their financial decision making behavior. The researchers found that, when shown erotic pictures, the young men took more risks; conversely unpleasant pictures made them take lower risks. The part of the brain that lit up during this experiment was found to be the 'accumbens' often called the brain's 'pleasure center'. It has also been found that this part of the brain lights up in anticipation of pleasure/reward.
Anyone who has read the very funny Liar's Poker, by Michael Lewis, or witnessed the sometimes bizarre behavior of the grown-up schoolboys who inhabit the adventure playgrounds that some banks call dealing rooms, will be aware that testosterone and money is a very potent mix. Contrary to the basic tenets of financial economics, not all traders exhibit strictly 'rational behavior' all of the time.
Risk managers may be able to use this information to their firm's advantage. For example, if a trader's Value at Risk (VaR) is close to its limit, pictures of East German women weightlifters, circa 1970, could be displayed on their market data screens. On the other hand, if VAR, Vega and Gamma are nicely aligned and well within their limits, traders could be encouraged to take more risk, by showing pictures of Cameron Diaz (or Tom Cruise depending on preference). This would add a new meaning to the study of 'tail dependence'.
Enough of the bad jokes! This research into risk-taking behavior is serious and deserves to be taken seriously.
It was apparent that the rogue traders at the heart of the NAB and Societe Generale scandals were influenced by their upcoming, i.e. anticipated, bonus payments to take unwarranted, and ultimately disastrous, risks. Could it be that telling someone that they are about to receive a bonus might actually cause them to take more risks? If such a link was proven, then there might be a better way to incentivise traders, such as announcing bonuses early, to reduce the anticipatory impact, but making their release conditional on traders proving that they are fully compliant with all risk policies and procedures - i.e. putting the onus of proof of risk management back onto the risk takers. That would surely dampen risky behavior.
Likewise, there is immense market activity in advance of announcements, such as Fed interest rate decisions and the stock market profit-reporting season. Are all market decisions during the run-up period to such announcements based on sound analysis or could they be affected, even marginally, by anticipated outcomes? Any 'irrational' behavior based on emotion would unnecessarily increase volatility, which is generally not conducive to orderly markets.
There is ample evidence in Behavioral Finance that personal 'cognitive biases' play a crucial part in decision making. Selective use of information (confirmation bias) and groupthink are traits that many financial decision makers appear to exhibit. The use of new MRI techniques will help us to understand the physiological basis for such behavior and ultimately, may be used to distinguish between good and bad decision makers.
The financial services industry should seriously consider funding further research in the new discipline of neuroeconomics because its results should help to reduce risks throughout the industry. For example, if a trader, or any other risk taker, could be trained to be aware of when they are in danger of taking unwarranted risks, then Cognitive Behavioral Therapy techniques could be used to help them get back onto an even keel. Likewise on a practical level, there is a need for research into how information should be displayed, such as choice of colors or visual layout, so that traders make less emotional decisions.
Could this research lead ultimately to a change in hiring policies in the financial industry, away from nuclear physicists towards psychologists? This could be very timely, as many involved in the subprime crisis would appear to need their heads examined!
 Knutson B., Wimme, G., Kuhnen, C. and Winkielman, P. 'Nucleus accumbens activation mediates the influence of reward cues on financial risk taking' Neuroreport 19(5): 509-513, March 2008
 Lewis M. 'Liar's Poker: Rising Through the Wreckage on Wall Street' WW Norton 1989
Posted by pjmcconnell at 05:05 AM
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