The same brain functions that enable people to be socially successful can also lead to financial ruin, according to a study

Brain Scans Show Social Signals Used to Build Bubbles

The same brain functions that enable people to be socially successful can also lead to financial ruin, according to a study. The ability to understand the intentions or thoughts of others, known as “theory of mind,” is a fundamental tool of social interaction. As financial bubbles are forming, activity is heightened in the area of the brain associated with theory of mind, according to a study of 21 men participating in experimental markets. The research, led by Benedetto De Martino at the California Institute of Technology, was published today in the journal Neuron.The finding, coming five years after the collapse of Lehman Brothers Holdings Inc., adds to other research in behavioral finance and economics that seeks to explain the mysteries of markets. Andrew Lo, a finance professor at the Massachusetts Institute of Technology, showed in an earlier study that emotions, namely fear and greed, rather than rationality plays a significant role in traders’ decision-making, as observed in responses such as heart rate and blood pressure.

“We’ve shown that an ability that is normally beneficial in social settings, within complex systems, like financial markets, can result in unproductive behavior,” said De Martino, who is now a senior research fellow at Royal Holloway University of London, in a telephone interview. In bubble situations, traders “become less driven by explicit information, like actual prices, and more focused on how they imagine the market will change.”

Brain Imaging

The researchers used functional magnetic resonance imaging to measure the flow of blood in various parts of the brain as pre-programmed trading activity was replayed in front of the traders over two days. They were given $60 to participate at random intervals. Three of six sessions involved inflated markets, where prices rose well above intrinsic values, and where more activity was observed in that part of the brain known as the dorsomedial prefrontal cortex, which is associated with theory of mind.

Identifying this brain activity may help explain how so-called “irrational exuberance” develops without the knowledge of investors, said Michael Hughes, head of client services at Trinity Street Asset Management in London and former fund manager at JPMorgan Asset Management.

Human Interactions

“The markets are the result of a series of human beings interacting with each other in ways that are human rather than automated,” Hughes said in an interview. “Bubbles can be long-term in forming, and a lot of people don’t even know that they’re occurring until it’s too late.”

While theory of mind was shown to lead to harmful bubbles, shutting down this activity isn’t necessarily a solution, especially if there are insiders in the market who have information with real value, De Martino said.

“It really depends on the context,” he said.

The process can also be used to take advantage of anomalies in markets, Hughes said.

Studies such as the one published today have been made possible by advances in computing power to analyze data and technology such as fMRI, De Martino said. That allows scientists to go one step further than the theoretical work done by behavioral economists.

“So now we can say, if you see a watch and it’s moving in a funny way, rather than trying to understand what the watch is doing, just open the watch and see what is happening inside,” he said.

The study was funded by the Wellcome Trust, the Betty and Gordon Moore Foundation and the Lipper Family Foundation.

To contact the reporter on this story: Makiko Kitamura in London at mkitamura1@bloomberg.net