Neuroeconomics redux

28Sep06

One interesting aspect of behavioral finance is that we continue to advances in the state of the art of brain imaging technology. Therefore as our understanding of how the brain works necessarily trickles down into our understanding of how individuals make economic-related decisions.

We noted in an earlier linkfest a magazine-length piece on the growing field of neuroeconomics by John Cassidy in the New Yorker. In it he does a nice job of summarizing what behavioral finance and neuroeconomics is all about.

In order to depict economic decisions mathematically, economists needed to assume that human behavior is both rational and predictable. They imagined a representative human, Homo economicus, endowed with consistent preferences, stable moods, and an enviable ability to make only rational decisions. This sleight of hand yielded some theories that had genuine predictive value, but economists were obliged to exclude from their analyses many phenomena that didn’t fit the rational-actor framework, such as stock-market bubbles, drug addiction, and compulsive shopping. Economists continue to study Homo economicus, but many recognize his limitations. Over the past twenty-five years, using methods and insights borrowed from psychology, they have devised a new approach to studying decision-making: behavioral economics.

There are a number of results stemming from the use of non-intrusive brain imaging techniques one of which is of interest to investors of all stripes.

The results of the experiment suggested that when people are confronted with ambiguity their emotions can overpower their reasoning, leading them to reject risky propositions. This raises the intriguing possibility that people who are less fearful than others might make better investors, …

While neuroeconomics is clearly applicable to finance and economics it also has some implications for public policy as well. As a counterpoint, at least in regards to the policy implications of neuroeconomics, Will Wilkinson at TCS Daily has a piece up calling into question a certain level of “paternalism” implied by certain neuroeconomics findings.

The question of how the brain processes information including letters and words also arises in a piece by Jennifer Valentino in the Wall Street Journal. In the article she reviews two new academic papers that demonstrate that the nature of a company’s stock symbol may affect the performance of the stock itself. So-called ‘memorable’ tickers like, Southwest Airlines (LUV) seem to convey some sort of advantage.

On the face of it this seems absurd. Believers in efficient markets would argue that the stock symbol is utterly irrelevant to the performance of a company’s stock. Whatever the stock symbol, the underlying fundamentals of the company, including sales, earnings, cash flow and book value are the same in any scenario. Then why might there be an effect?

One explanation posited in the piece is that stock symbols act as a very public “signal” to investors that the management team is indeed clever and on the ball. Another more interesting explanation is that somehow more fluent symbols affect us psychologically.

The idea that clever or pronounceable ticker symbols might better stick in investors’ memories is an important component of both recent studies. Neither report proves causality, but one possible explanation for the results is that people prefer to work with information they can easily process.

When faced with complicated information — say, stock listings — people have a tendency to rely on mental shortcuts to simplify things…

The article correctly notes that investors should not rely on a company’s symbol to buy or sell a stock, but the underlying thesis that investors are affected by things other than fundamental data is indeed intriguing.

One of the first lessons in any statistics class is that “correlation does not imply causation” as noted above. Greg Mankiw is irked by yet another example in the press where statistical data was misued in implying that causation flowed from correlation.

Further on the subject of economics, Tyler Cowen at Marginal Revolution has some speculation on this year’s Nobel Prize winners in Economics. Future Nobel Prize winners will surely come from the ranks of economists using behavioral techniques. Speaking of which, can you believe people actually bet on this stuff?

Researchers in the fields of behavioral finance and neuroeconomics have, in a sense, the wind at their backs. As brain imaging techniques and technologies advance they will have a steady flow of novel approaches which they can apply. While we will never fully appreciate all the nuances of the brain’s approach to economic questions, we can at least take comfort in the fact that we know more now than we did.

*For those really interested in the subject of the brain, The Economist reports on a scientific project that has created an “atlas of the brain.”

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