The Why Files The Why Files -- whyfiles.org

Stem cells + 10: Lessons limits and laments
POSTED 23 OCTOBER 2008

Wall Street: Home of the investing primate!

One way to understand how we think about money is to consult a neuroeconomist -- a parson who marries economics to the study of brain structure and function. The Why Files phoned Michael Platt, an associate professor of neurobiology at Duke University, who described economic decisions made by a brain that's rather like ours -- the brain of a monkey. "I try to understand the simple decision-making mechanisms that are in place in animals, which seem to be the same as those in our brains," says Platt.

 Illustration of terrified man
"The Expression of the Emotions in Man and Animals," Charles Darwin, Wikipedia
Is this man watching a rampaging tiger, or the plunging London stock market?

And what has the good professor learned about the role of brains in the Wall Street roller-coaster? It's commonplace to see the daily gyrations as evidence for panic, but Platt says the shocking evaporation of trillions in paper wealth may actually have put investors into rapid-learning mode. "We have learned from several decades of animal research, and now human research, that you learn by comparing expectations with outcomes," says Platt. "When the difference is really big, you learn fast, and can make a rapid change in behavior."

Great expectations

When we expect an investment to soar like a hawk on an updraft, and instead it plummets like a Finn on a ski jump, a signaling molecule called dopamine is released in the brain. This powerful agent is also activated by drugs like cocaine, says Platt, "and the more dopamine that gets released, the faster you learn."

In addition to dashed hopes, the bum-dom of the situation also accelerates learning, Platt adds. "We know that animals learn much more quickly from aversive experiences. So when people have a negative experience, when a stock does not pay what it was predicted to pay, that could provide a very strong learning signal that drives subsequent behavior."

General Motors stock has skidded 82 percent in 12 months, providing exactly the kind of "strong learning signal" that would catch the attention of any investing monkey: Once burned, twice shy. Platt does not sell stocks to monkeys -- although non-human primates could soon be the only market for some stocks -- but instead gives them simple gambling tests. In one test, they can choose between a safe choice with a reliable payoff, or a risky choice that delivers a jackpot -- or nada.

In these tests, Platt says, "The monkeys develop a simple strategy called 'win-stay-lose-shift.' Whenever they get the jackpot, they keep going back to that option." But when the risky option turns sour, the monkeys move to "lose-shift," Platt says, "They run away 90 percent of the time, and it's not far-fetched to think people are doing something very similar" when they invest.

(Sound like anybody you know?)

Elderly people inside the Trump Taj Mahal, with glittery lights
Photo: Raul654
When monkeys are taught to gamble, they can teach us about human attitudes toward money and investment. These slot-machine addicts are in Atlantic City, New Jersey.

Speed kills!

In the monkey market, fast decisions tend to favor risk, Platt says. "Monkeys love to make decisions really fast, especially if they hit the jackpot several times in a row. But if they slow down, they will 'consider' their options, think about it, and then start being very risk-averse, where they don't care for the jackpots."

A similar phenomenon can be seen among financial traders, Platt says. "If something makes them slow down, they are much more likely to buy the [safer] bond, so to speak, rather than the risky stock."

Wall St. is all about risk, yet monkeys and people are frightened of risks they can't assess. "People hate ambiguity," Platt says. "If you hide information, say you have a new car with no history of reliability, people are not going to be interested in buying it," over a car with a known record of reliability. Although such experiments are difficult to do in animals, which seldom have driver's licenses, "We have good evidence that monkeys appreciate ambiguity and will do everything they can to avoid it. We believe we are uncovering a specific brain mechanism that controls this avoidance."

Tan Macaque perched upright on building corner
The rhesus macaque is a favorite subject of primate studies, including those that focus on finances. Will this monkey buy a credit default swap, or a collateralized debt obligation?

Unambiguously despising ambiguity

Economists define ambiguity as a situation where you don't know the probability of various outcomes, and by definition, all stocks are at least somewhat ambiguous. When you buy shares in Ceramic Research Under Development (symbol: CRUD), you have no way of knowing tomorrow's price. But the uncertainty becomes extreme when the stock market is gyrating as it is today; the price of CRUD could slide 20 percent in a day, like some brand-name bank stocks.

Ambiguity bothers animals, and also people, according to Ming Hsu, an associate professor of economics at the University of Illinois at Urbana-Champaign. "Ambiguity is an aversive signal in the brain that tells you that you are missing information you need to make a decision, and that will force you to stop making decisions to get the information."

A part of the brain called orbitofrontal cortex, located behind the forehead, seems to be involved economic decisions made in uncertain conditions, Hsu says, adding that people with damage to this region also have a more general difficulty in making decisions.

An uncommon tragedy?

The take-home message is this: When markets reach today's level of instability, ambiguity soars, the brain becomes overloaded, and investors freeze up.

If stockholders are unwilling to buy or sell, markets stop functioning, and the agony of ambiguity extends beyond individuals to corporations, Hsu says. Facing unprecedented turmoil, many banks have stopped lending while they decide on the next step, contributing to the current credit crisis in the financial markets.

This cessation may make sense, but only in the small picture, Hsu says. "It might be individually rational for a bank to stop lending, but collectively, it creates a tragedy of the commons, and the whole credit market can go down." (The tragedy of the commons exists when actions that benefit individuals harm the group. It was named for an ancient dilemma: If farmers graze animals on commonly owned land, they benefit from maximizing their use of the free pasture, but everybody suffers due to overgrazing.)

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Terry Devitt, editor; Nathan Hebert, project assistant; S.V. Medaris, designer/illustrator; David Tenenbaum, feature writer; Amy Toburen, content development executive

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