Traders that make money have a brain area that becomes active during the peaking phase of a price bubble that tells them to sell, according to a recent study reported in the Proceedings of the National Academy of Sciences. The area of the brain is called the anterior insular cortex and it is associated with a feeling of discomfort. It seems that when prices are rising too high for comfort, traders that make money in the market “get a gut feeling” from this activity in the brain and then decide to sell.
The researchers in the study used functional magnetic resonance imaging (fMRI) to study the brains of traders as they viewed price bubbles forming and crashing in an experimental fake market set-up. A total of 320 subjects were given 100 units of fake money and 6 shares of an asset during the study. The asset price was set to vary widely while participants were undergoing fMRI testing. Alec Smith and Colin Camerer carried out the study and it was performed at California Technical Institute and Virginia Tech.
The results showed that neural activity in the nucleus accumens (sometimes called the pleasure center or reward center) tracked the developing price bubble. The traders that did not make much money tended to buy as a function of nucleus accumens activity. This means they kept buying as long as the brain reward center was active when the prices were going up. Presumably, watching the price of the asset go up created pleasure and a sense of reward. The authors of the study point out that watching the activity assisted with predicting future price changes and crashes.
The study results showed that activity in the anterior insular cortex preceded an impending price peak, which was followed by a price crash, in the highest earners. This was described as a neural early warning signal in the brain that the higher earners experienced. This part of the brain was described as signaling discomfort and the traders that make money were able to sense this discomfort and act on it. That is to say, they could sense a bubble burst coming and decided to pull out before it happened. The anterior insular cortex has previously been shown to be activated when people are taking financial risks.
The low-earning traders did not get the early warning signal and stayed in until the bubble burst. The authors of the study described this as emergent group-level activity exhibiting a mistaken belief or validation. In plainer English, they were hood-winked by the nucleus accumens reward activity and continued to buy at the peak of the bubble. A term coined by Alan Greenspan, former Federal Reserve chairman, aptly fits this behavior. He called it “irrational exuberance.”
The way to make money in the stock market is to buy low and sell high. The brain activity that gives warning to buy or sell could be an indicator of either changes in a physical or mental state. In any case, brain activity in the nucleus accumens or anterior insular cortex may relate to trading behavior and success. Traders that make money seem to get a warning signal in their brain, and listen to their gut feelings, to tell them when to buy and when to sell.
By Margaret Lutze