craschworks

http://www.boston.com/dailyglobe2/296/science/The_biology_of_irrational_exuberance_P.shtml

The biology of 'irrational exuberance'

Research finds body responds to market swings

By Gareth Cook, Globe Staff, 10/23/2001

When Alan Greenspan coined the phrase ''irrational exuberance,'' he
was cautiously telling America that investors had begun to create a
stock-market bubble. He was right.

Now it looks like he might have been onto some serious science as
well.

In a yearlong study at a major Boston financial company, researchers
from the Massachusetts Institute of Technology and Boston University
found that professional currency traders react to changing markets not
just with their brains, but also subconsciously – with their whole
bodies. As they sit at their desks moving millions of dollars through
the financial system, their vital signs react almost instantaneously
as prices dip and rise.

They are, in other words, wired to the market.

Like bond traders and stockbrokers, foreign-currency traders are paid
to act rationally – to ignore the waves of emotion that consume
amateur investors. Yet all of the currency traders in the new study
showed a clear physiological response to what the markets did,
experiencing powerful surges – jumps in blood flow, sweating – with
every rally and reverse. A strong emotional reaction was clear in
regions far from the rational mind.

The research, conducted by an MIT economics researcher and a
neuroscientist at BU, adds momentum to a growing revolt against
classical economic theories, which assume people will always make
decisions by thinking and acting rationally.

A growing group of economists has been arguing that financial markets
do not always behave in a rational way. They go through panicky
stock-market selloffs or dramatic spikes that cannot be easily
explained by reasoned behavior.

A better model, the new study's authors believe, will develop when
economics can find a place for the irrational quirks of human
nature. And their paper, accepted for publication in the Journal of
Cognitive Neuroscience, is the first such study done outside a
laboratory, opening up a new kind of research into how people actually
make decisions and respond to risk.

''This is an important paper,'' said Hersh Shefrin, a professor of
finance at Santa Clara University. ''These are real traders in
real-life settings.''

The researchers wired traders with equipment that measures their heart
rate and perspiration, and compared the results to a chart of the
day's ups and downs. They did not, however, match the traders'
reactions with the decisions they actually made. In other words, the
study showed how their bodies reacted, but not what their brains told
them to do.

But the researchers did find something surprising: After watching the
results, they could gauge traders' experience level solely by how
their bodies behaved as they worked. Novice traders reacted
strongly. Experienced ones displayed a more even keel.

''What most surprised us was the ability to distinguish experienced
traders from less experienced ones,'' said Andrew Lo, co-author of the
study and director of MIT's Laboratory for Financial Engineering at
the MIT Sloan School of Management.

That finding eventually could have some practical uses in the
financial world. MIT is about to file a patent on the technique, which
Lo said he hoped to refine so that banks could use it to screen job
applicants – and perhaps, if scientists discover how the emotions
affect decisions, to train and even monitor their traders.

Analysts said the research is not yet practical enough to be of any
use to financial institutions. How people perceive risk is a vital
area, though, for companies that invest other people's money,
according to Arnold Wood, president and chief executive officer of
Martingale Asset Management in Boston. If there were a better way to
assess how much risk investors were willing to take on, it would be
easier to construct investment portfolios tailored to their needs.

To Lo, however, it's the broader implications that drove him to the
work.

''I was led to this research by force,'' Lo said, ''because the
standard paradigms we use in economics and finance have not
progressed.''

Classic economics assumes that people are rational and greedy, always
making choices that will bring them the most expected incomes. From
this assumption, economists have then been able to build elaborate,
mathematically precise theories.

''At one level, the logic of economics is so rigorous, but it is built
on a foundation of folk psychology that we would mock in other
fields,'' said Terry Burnham, a visiting assistant professor at the
Harvard Business School.

In the last two decades, a growing body of critics have been
cataloguing the many ways that the classical view of ''homo
economicus'' fails. Economists have observed, for instance, that a
person will usually feel better off if he receives a raise – but can
feel worse off if he is given a raise while a co-worker receives a
larger raise.

Economists say this research, called behavioral economics or
behavioral finance, has succeeded in proving that classical economics
has flaws, but has failed to offer a viable alternative, causing some
researchers to look for a new foundation, perhaps in biology.

To investigate the role of emotions in economic activity, Lo teamed up
with Dmitry Repin, a neuroscientist at Boston University who made the
research a part of his doctoral thesis. The two then approached what
they describe as ''a major global financial institution'' – which
participated on the condition of anonymity – about enlisting traders
in currencies and interest-rate derivatives in the test.

Working last year, the team outfitted 10 employees with equipment that
measures data – such as pulse rate, skin conductance, and respiration
rate – that researchers know is closely related to emotion. The data
only indicate when someone is having an emotional response, Repin
said, not what emotion they are experiencing.

The traders were then allowed to work as they normally would, and the
team recorded their responses while tracking ''market events,'' such
as a sudden bump in price. All of the traders responded emotionally to
the market events.

Lo said that he has been amazed at how strong an emotional link
traders form with the market – and how clearly experience can change
their response. He said he was demonstrating the equipment to a class
when he saw one student exhibit the distinctive pattern of a more
experienced trader. It turned out the student had traded bonds for
several years.

It was as if her emotional circuitry, he said, had been permanently
changed.

This story ran on page C1 of the Boston Globe on 10/23/2001. �
Copyright 2001 Globe Newspaper Company.