BeFi Web Seminar for May 30, 2007
Minds and markets:
Some frontiers of behavioral finance
© BeFi Forum 2007
by Colin Camerer
Caltech
Minds and markets:
Some frontiers of behavioral finance
Colin Camerer, Caltech
camerer@hss.caltech.edu
• See opportunities others don’t see
– Psychology: Attention + curiosity
• Understand the fears and hopes of investors
– Psychology: Prospect theory
– Neuroscience: Fear of the economic unknown
New GAIM 2007 Monaco
1. See opportunities others don’t see
• Conscious attention is limited
– “Flicker” paradigm
– Top-down encoding: “I’ll believe it when I see it”
• Visual and cognitive illusions
New GAIM 2007 Monaco
How many F’s are there?
FINISHED FILES ARE THE RESULT OF YEARS OF SCIENTIFIC STUDY COMBINED WITH
THE EXPERIENCE OF YEARS
New GAIM 2007 Monaco
How many F’s are there?
Answer: 6!
FINISHED FILES ARE THE RESULT OF YEARS OF SCIENTIFIC STUDY COMBINED WITH
THE EXPERIENCE OF YEARS
• The brain ‘sees sounds’ and
automatically encodes “of” as “ov”
New GAIM 2007 Monaco
How far can attention go?
• Attention can be
stretched but
memory suffers
• E.g. “I Love Lucy”
chocolate factory
episode
New GAIM 2007 Monaco
Do markets have ADD?
• A. Earnings announcements
– Friday reaction is slower
• B. Distant demographic effects are underpriced
– Bicycles and drugs
• C. Attention-grabbing events drive volume
– Barber-Odean
• D. ENMD (reading the market’s reading)
– Nature vs New York Times
• E. Paying attention makes you smarter: Curiosity
New GAIM 2007 Monaco
A. Earning reports:
(dark blue) Fridays react more slowly
(Della Vigna-Pollet 06)
New GAIM 2007 Monaco
B. Demographic profiles for
bicycles (red) & drugs (blue): Investors
look only 5 (…years!) ahead
New GAIM 2007 Monaco
C. Attention-grabbing events  volume
• High-volume or high-volatility stocks get
20% more individual investor trade (BarberOdean 06)
New GAIM 2007 Monaco
D. news (Nature) vs. NEWS (NYTimes)
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E: Paying attention makes you happy
and smart(er):
Curiosity is the hunger pang of an info-vore
• Einstein: “I have no special
talents. I am merely
passionately curious”
• The wick in the candle
of learning
New GAIM 2007 Monaco
Curiosity-piquing question
• What animal excrement is eaten as a
delicacy?
New GAIM 2007 Monaco
Curiosity-piquing question
• What animal excrement is eaten as a
delicacy?
• A: Bat guano
New GAIM 2007 Monaco
Curiosity activates reward areas…
• “Striatum”
activated by:
– Cocaine
– Money
– Expected
return
– Faces of
cooperators
– “warm glow”
charity
– information…
when you
are curious
New GAIM 2007 Monaco
…and curiosity enhances memory:
highly curious remember wrong
answers twice as often
New GAIM 2007 Monaco
2. The fears and hopes
of investors
• Prospect theory:
– Hate to lose compared to a reference point
– Overweight or ignore rare “black swan” events
– Fama: “morbid fear of a recession”
• Preference for the familiar
– “Home bias” (countries, Baby Bells, local firms)
– Aversion to unfamiliar activates fear areas
New GAIM 2007 Monaco
Prospect theory value Function
A special role for losses
•
Kahneman & Tversky (1979) most-cited empirical paper in economics
post-1970
Gains = x(ρ)
Losses = -λ*(-x)(ρ)
New GAIM 2007 Monaco
Nonlinear weighting of probabiltiy
in choices↓
and in the brain
↓
New GAIM 2007 Monaco
Overweighting low probability
is severe– a quantum of possibility?
– π(p)
α
(ln(1/p))
=1/e
(α=1 linear)
– Typical measured value (α=.77)
•
•
•
•
π(.10)=.15
π(.01)=.04
π(.001)=.012
π(.000001)=.000515
(x1.5)
(x4)
(x12)
(x 515)
New GAIM 2007 Monaco
Increased gain/reduced loss
activates striatum….
brain (x) correlates
with behavior
(y)
(Tom et. al. 07 Sci)
New GAIM 2007 Monaco
Can investors be immunized
against loss-aversion? Maybe…
140 choices gamble vs. guaranteed
p=0.5
Risky
Gamble
Guaranteed
p=0.5
New GAIM 2007 Monaco
Accept the gamble?
Emotional down-regulation:
Instructed to ‘think like a trader’…
One way to think of this instruction is to imagine
yourself a trader. You take risks with money every
day, for a living. Imagine that this is your job, and
that the money at stake is not yours – it’s someone
else’s. Of course, you still want to do well (your job
depends on it). You’ve done this for a long time,
though, and will continue to. All that matters is that
you come out on top in the end – a loss here or there
won’t matter. In other words, you win some and you
lose some.
New GAIM 2007 Monaco
Down-regulation decreases
biological response to actual loss
• Decreases skin
conductance (not shown)
Decreases activity in
right amygdala (crosshair location)
217 voxels
tmax= 72.78
p < .006
New GAIM 2007 Monaco
Down-regulation of loss-aversion
lowers measured λ
(λ”Attend” - λ”Regulate”) as percent of λ”Attend”
% DECREASE IN LAMBDA
0.6
0.5
The down-regulation strategy decreases
loss aversion (t=5.40 p<.000003 N=45, Paired t-
0.4
test)
0.3
0.2
0.1
0
-0.1
-0.2
INDIVIDUAL
SUBJECTS
New GAIM
2007 Monaco
(caveat re: ρ)
Fear of the economic unknown
(e.g. home bias in investing)
New GAIM 2007 Monaco
fMRI shows brain areas
New GAIM 2007 Monaco
Activation when fearing the
economic unknown
New GAIM 2007 Monaco
In the news
April 20, 2006
ECONOMIC SCENE
Enter the Neuro-Economists: Why Do Investors Do
What They Do?
By TYLER COWEN
A neuro-economics laboratory at Cal
Tech, led by Colin F. Camerer…has
assembled the foremost group of
interdisciplinary researchers….
….
New GAIM 2007 Monaco
Conclusions & the future
• 1. Missing attention  profits
• 2. Fears and hopes of investors
• Science fiction:
–
–
–
–
–
Predicting bubble crashes from brain signals
Collective attention (herding…)
Measuring risk propensity neurally
Changing reactions to loss (down-regulation)
Identifying great traders, rogue traders, and
burnout.
New GAIM 2007 Monaco
PRESENTED BY
Shlomo Benartzi
Co-Founder, BeFi
Associate Professor Co-chair of the
Behavioral Decision Making Group
The Anderson School at UCLA
Warren Cormier
© BeFi Forum 2007
Co-Founder, BeFi
President, Boston Research Group