If you lost money in the last bubble market there are a lot of things you can blame—a bad tip, a hunch gone wrong. But don’t let your dorsomedial prefrontal cortex off the hook. That bad boy can cost you a bundle.
The dorsomedial prefrontal cortex (dmPFC) is located in the forward part of your brain and is usually quite the good citizen. It’s in that spot that you process feelings of altruism. It’s there too that you make the instinctive judgment about the person you meet at a singles bar who instantly—and usually correctly—strikes you as either a rare find or bad news. And, according to a new study in the journal Neuron, by researchers at the California Institute of Technology, it’s there as well that you make the often disastrous decision to jump into or out of a wildly fluctuating market.
One of the reasons people participate at all in market bubbles is their belief that somebody knows something they don’t. If real estate or tech or the health sector is booming, there must be a reason, and if you study the numbers and think hard enough, you can figure out what’s going on in the heads of other investors that’s driving prices up or down. This ability to know what someone else is thinking is not an illusion. It’s called the theory of mind, it lives in the dmPFC and it boots itself up early in life. In an oft-cited study, an experimenter playing with a toddler younger than three will conspire with the child to hide a toy. When another researcher comes into the room, the child will assume that that person too knows where the toy is—the assumption being that all knowledge is universal knowledge. It’s only a little later that kids appreciate that knowledge is particular to the person, and so are feelings. With that comes empathy (even if I’m feeling happy you might be feeling sad) as well as a willingness to learn from other people—and to try to intuit the knowledge they’re not actively sharing.
To test what role this plays in markets, the Caltech investigators placed subjects in a functional magnetic resonance imager (fMRI) and had them watch a recorded session of other people participating in a market-trading simulation game. In some of the trials, the game resulted in a bubble market, with the share price of the imaginary asset rising far above its intrinsic worth. In other sessions, the trading proceeded more conservatively and predictably. In all of the sessions, the subjects in the fMRI were periodically asked to imagine they were participating in the game and to invest part of a stake of $60.
Some of the subjects invested only sparingly in the boom and bust trials; others actively participated in them, risking a significant share of their own $60. During all of the trials, all of the subjects showed increased activity in a brain region known as the ventromedial prefrontal cortex (vmPFC), which is sort of our internal bean-counter, making judgments about the value and the cost of things. In some subjects there was also an uptick in activity in the dmPFC, and the greater that activity, the greater the fluctuation in those subjects’ portfolio values.
To determine if this was indeed a sign of the brain trying to mind-read other market players, the investigators had the subjects take another, much simpler test, known as “the mind in the eyes” experiment. As the name suggests, the test involves looking at pictures of people expressing different emotions and identifying what those emotions are; to increase the degree of difficulty, only the eyes and the region of the face immediately around them are shown. The people who did best on that test turned out to be the same ones who’d had higher activation of the dmPFC in the investment game and the greatest portfolio fluctuation—for better or worse. Said principal investigator Colin Camerer in a statement accompanying the release of the study:
“The way we interpret this is that these people were thinking more about what was going on in the market and wondering why people were behaving the way they were. Normally, in everyday social encounters and in specialized professions, this kind of mind reading is useful to the individual. But in these markets, when prices are going crazy, these people think, ‘Wow, I think I can figure these markets out. Let me buy and sell.’ And that is usually going to contribute to the bubble’s momentum and also cost them money.”
The idea that you can read the minds of the people who know what’s going on is not the only illusion at work. The other is that those knowledgeable people exist in the first place. Paradoxically, it’s the very volatility of the trading that creates that impression. Markets are supposed to be rational things, guided by the endlessly invoked invisible hand. If those markets are going nuts, someone must be steering the hand that way for a reason. Said Peter Bossaerts, another of the paper’s authors:
“When participants see the inconsistency in order flow, they think that there are people who know better in the marketplace and they make a game out of it. In reality, however, there is nothing to be gained because nobody knows better.”
Five years almost to the day after the crash of Lehman Brothers, a phrase like “nothing to be gained because nobody knows better” should perhaps be tattooed on the forehead of every trader on the planet. Theory of mind is a wonderful thing when there’s actually another mind to be read. Markets don’t have minds, however, they only have wealth. Forget that fact and they could have yours.