Dr. Benedetto De Martino is a a cognitive neuroscientist who works in the field of decision making and neuroeconomics. In this paper he set out to understand what is going on inside our brains during financial bubbles, and joined forces with John P. O’Doherty, Debajyoti Ray, Peter Bossaerts, and Colin Camerer.
Financial bubbles have been forming and busting for more than 4 centuries. When they form, we understand that something is wrong, but fail to act on time. Why?
A ‘bubble’ happens when active trading of an asset reaches prices that are considerably higher than its intrinsic value and it appears the source of this phenomenon is at the heart of our social behavior.
On any given day, we interpret countless social situations, without ever thinking about it. The area responsible for computing social signals is at the prefrotnal cortex, and so is the area in charge of processing value judgments, another key human characteristic.
Researchers at the California Institute of Technology investigated what happens in these areas during financial bubbles. 21 students were examined using MRI as they traded shares within a staged financial market.
They traded in normal trading conditions –when shares displayed reasonable prices – as well as in bubble conditions.
In normal conditions, the flow of traders’ orders was steady. However, under bubble conditions, the flow was choppy, suggesting trades were bunching up around new information or pausing to see what happens next.
This attempt, to imagine how other traders will behave, changed their judgment of how valuable assets were. Which is exactly how bubbles form.
Biologically speaking, In bubble markets, the part of the brain that is responsible to infer the intentions of other people and predict their behaviour biases signals in the part responsible for value processing
People naturally understand this situation as any social one, and start seeing the market itself as a strategic opponent
What’s the bottom line?
The ability to infer intentions of other agents, called Theory of Mind, confers strong advantages for individuals in social situations, but it can also result in unproductive behaviors within a complex modern system, like financial markets, driving a cycle of boom and bust.