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Lessons for traders from neurofinance research

Neurofinance is one of the sub-fields in the area of Behavioral Finance research. It’s the area which focuses on how out brain works. During the conference I attended last week there was a set of presentations on the subject that were very interesting. I thought they would be well worth sharing here.

The impact of learning
One of the papers presented was titled “Brain, Financial Market Bubbles, and Investing” by Dr. Paul Zak from Claremont Graduate University. Basically, Dr. Zak described an experiment he was part of running in which the impact of learning was gauged in terms of the actions of “traders” in the formation of bubbles. The conclusions were interesting.

The bubble experiment is one where a group of people are given the opportunity to trade a fictional market for a depreciating asset. By definition, this is a market that must eventually go to zero, yet consistently through these sorts of experiments there are clear bubbles being formed in the markets (meaning prices go well above fundamental value). Research has found, however, that as participants repeat the experiment the bubbles tend to become less extreme, indicating a learning aspect.

The experiment about which the Zak paper was written was an effort to see just how significant that learning factor is in bubble formation. Using drugs, the researchers impaired the learning facility of about a third of participants. The result was that those traders did not learn as quickly as the others, and thus it took longer to see the same reduction in bubble formation than in the non-drugged group (actually, the non-drugged group was 50% on a placebo and 50% on caffeine pills, but there was no significant difference in performance).

Zak’s conclusions were three-fold. First, market participants must learn market history so they know what the market has done before. Second, learning must be “salient”, meaning it involves actually risk and reward (in other words real money trading, not demo trading, as I have suggested on many occasions). The last was that trading frequency relates inversely to the potential for a market to form a bubble (think real estate as a prime example).

Understanding your brain
[easyazon-link asin=”0470543582″][/easyazon-link]The other key presentation in this area was from Richard Peterson, co-author with Frank Murtha of [easyazon-link asin=”0470543582″]MarketPsych: How to Manage Fear and Build Your Investor Identity[/easyazon-link]. Peterson made two really interesting points that I think traders should latch on to as part of their development.

First, from a real neuro perspective, he noted that greed actually turns off the fear centers in the brain. This is scientific evidence of what many traders already know – that when we start thinking overly much above what we could make in the market it shorts out the part of our brain where we process the risk. As a result, we take too much risk and otherwise act stupidly.

The other point Richardson made was that we are naturally inclined to want to “do something” in times of stress. This is where a good trading plan comes in (see my series of trading plan posts). It gives us specific action items to do so that our natural instincts – which rarely work in our favor when trading – don’t override our ability to do what needs to be done, even if that is actually nothing at all.

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