Richard L. Peterson, M.D.

Market Psychology Consulting

San Francisco, CA  USA

Personal website


Last updated: March, 2005.


Probing the brain of an investor:  How advances in neuroscience are demystifying the markets


Episodes of extreme market volatility demonstrate the role of emotion-based trading in moving stock and commodity prices.  The internet stock bubble is an obvious example of emotions overtaking investors’ “common sense.”  More recently, the extreme moves of currency (e.g. USD) and commodity (e.g. gold and oil) prices prior to the invasion of Iraq in March 2003 illustrate the influence of anxiety in driving prices.  The power of the field of behavioral finance lies in its ability to predict and explain such emotion-driven price movements.


Behavioral finance encompasses the study of both repeating market patterns and “irrational” investor behavior.  The discoveries of behavioral finance are descriptive.   Understanding simply that a price pattern exists in the markets is much different than understanding why that pattern exists.  In order to gain a deeper understanding of what moves investors and markets, recent research has turned its focus toward studying brain processes themselves.


Studies of the brain (neuroscience) are teaching us how, why, and when investors make decisions to buy and sell.  If we know what information and emotional states will stimulate buying or selling, then more accurate (and profitable) forecasting models of the markets can be developed.  There are many applications of contemporary neuroscience research directly to investors participating in the financial markets.


Our primary goal is to understand the neural basis of investors’ buying and selling decisions.  On a large scale, this understanding will help us to create better market models (to ultimately reduce both price inefficiency and the risk of market crashes).  Individually, we can help investors decide what type of money-management strategy fits their unique personalities. 



Advances in neuroimaging technology allow us to see what happens in the brains of people who are faced with risky financial choices.  Neuroimaging technology provides a tantalizing view of the origins of investing behavior in the brain.  We can witness how information drives investing and how individual differences (such as personality) influence investing profitability. 



In order to understand the importance of neuroimaging to investors, some background information is helpful.  We must first emphasize that the potential of profit is what motivates investing.  In general, investors are motivated by money, and they will invest in those securities that they anticipate will produce the highest return over a given time.  Investors (ideally) place trades when they believe that their potential profit will outweigh their potential loss. 


Investing is a profit-seeking (reward-seeking) behavior.  Investing is actually similar to other types of reward-seeking behavior such as the pursuit of tasty food, pleasure-inducing drugs, and sex.  Reward-seeking behaviors are generated in an area of the brain deemed the “reward system.”  This system can be seen in action with neuroimaging scans. 


The reward system has several functions.  The reward system assesses reward values, prioritizes resource and energy expenditure, and motivates behavior to procure the most valued rewards.  Of course, we don’t always know which rewards will be the most lucrative.  To obtain the most lucrative rewards, optimum balance of the system is essential. 



A variety of personality styles exist.  It turns out that different personality traits are better suited to assessing and pursuing rewards in different environments.  Depressive people are better at analyzing details and thinking through problems slowly and deliberately.  Neurotic people have trouble making decisions and dealing with ambivalence (and may overtrade in sideways markets).  Extraverted people feel more positive and act more decisively towards potential reward than others.  In general, extraverts are more likely to jump at potential opportunities without gathering background information (e.g. more likely to buy internet stocks during the bubble).  Researchers have found that whether we pay too much attention to potential gains, potential losses, or have a balanced view of both is determined by our biological “hardware.” 


Personality traits determine how one responds to risky situations, new opportunities, and gain and loss.  In the future, neuroimaging techniques may help us diagnose and target interventions for poor financial deicion making. Someday soon we may even be able to identify individuals as superior long-term or short-term traders.  We will also be able to evaluate and rank portfolio management candidates. FMRI research by Brian Knutson and Camelia Kuhnen at Stanford University is investigating these concepts. 



There are several global characteristics of the reward system across individuals.  We can see, in the brain, how different presentations of rewards create positive or negative feelings.  We can assess the effects of reward predictors (cues), reward probability, reward magnitude, and risk and uncertainty on decision-making.  Reward predictors themselves activate a brain region associated with both positive feelings and high energy (excitement).  Reward predictors create an energetic, pleasant feeling that motivates behavior for reward pursuit.  This pleasant, energetic feeling is the result of increased levels of a brain chemical called dopamine.



Dopamine makes people feel positive, confident, and energetic.  Both cocaine and amphetamines (the U.S. Air Force’s “go” pills) increase brain levels of dopamine.  Using neuroimaging we have found that areas of the brain that release dopamine become more active during the anticipation of reward.  More dopamine is released if larger rewards are anticipated.  However, receiving an expected reward actually depresses brain dopamine levels (and positive feelings) slightly from during the period of anticipation.



The anticipation of getting a reward makes investors feel good.  Among securities, past price performance does not predict future returns, but it does increase our expectations of future returns. Additionally, as a previously owned security rises, investors feel positive, and are more confident in their investing abilities.  Expectations have a tendency to rise higher and faster than they can be fulfilled.  Expectations, when achieved, spawn higher expectations until a breaking point is reached and disappointment becomes inevitable.


From our neuroimaging studies we find that receiving a reward is not as satisfying as the anticipation of it.  Investors whose investments meet their performance expectations will often feel less positive, and more risk averse, after their expectations are met.  When people anticipate a reward that either does not occur when expected or is less than expected, they will feel disproportionately disappointed. 


One investing example is product releases.  Investors often buy corporate stock before the release of much-hyped new products and then sell the shares following the release (“buy on the rumor and sell on the news”); e.g. Pixar stock drops immediately after new movie releases and Apple stock drops after Macworld tradeshows (Tam, Wall Street Journal, 2001 and 2002).  Another example is the performance disparity between growth and value stocks.  Value stocks historically have outperformed growth stocks, perhaps because they don’t have an expectation of “growth” already priced in.  In general this expectation of growth is more easily disappointed than the neutral to negative expectations accompanying value stocks. 



Disappointed expectations, such as result from repeated investment losses, depress brain serotonin levels.  Decreased brain serotonin levels are associated with serious emotional and behavioral consequences, such as feelings of anxiety, depressed mood, increased impulsivity, and irritability.  These emotional states are biological protective mechanisms.  Anxiety and depression paralyze investors, preventing them from taking investment risk.  Impulsivity results in the investor trying different investing strategies (usually off his system) and over-trading in the frantic search for a profit.  Unfortunately for investors, emotionally-speaking losses are weighted negatively twice as heavily as gains are weighted positively (Kahneman and Tversky, 1992).  Given the double impact of losses, short-term investing (trading) can be an inherently self-destructive activity (unless investors can profit on more than two-thirds of their trades or not grow accustomed to expecting success).


Gambling and other addictive behaviors may be the result of a potent brain cocktail of decreased serotonin and increased dopamine.  Cocaine, amphetamines, and anticipating the “next big win” all make us feel more confident and happy by increasing our brain’s dopamine levels.  Unfortunately, when that big win doesn’t pan out, we feel doubly negative as our serotonin levels drop.  Now we’re more impulsive, depressed, and nervous.  The only way we know how to get out of this negative state is to find another big reward to anticipate.  Again, anticipation of reward now results in increased feelings of confidence and well-being that mask our deeper depression (low serotonin).  The positive feelings of reward anticipation, by briefly relieving our chronic depressed mood, are psychologically addictive.



In addition to reward anticipation, valuation is performed by the reward system.  Valuation of rewards is affected both by the time distance until the reward (less priority to the more distant rewards) and by a higher number of potential rewards (less attention available to assess each possibility).  Neuroimaging allows us to see what choice options are most valuable to people.  For example, if offered a choice between two rewards (a sports car or a limousine in one study), the brain will be more activated by the favored option (the sports car) (Erk et al, 2002). 


The brain’s valuation function is relevant to theories of options pricing.  For example, options premiums account for the price uncertainty that exists between the present time and their expiration date.  These premiums are typically approximate to their Black-Scholes expected values and dependent upon historical volatility.  The Black-Scholes equation itself is conceptually identical to a neural valuation model derived from neuroimaging data by Read Montague (Neuron, 2002).  These valuation equations are rough approximations, and our continuing neuroimaging research will examine the influence of expectations and news on risk assessment and discrepancies beween implied and actual options valuations.


Another valuation phenomenon is the lofty valuations given internet stock IPOs without profits during the internet bubble.  Companies without profits saw their valuations rise more, post-IPO, than profitable companies.  It is now known that our emotions will strongly influence assessments of those stocks about which we have less information (McDonald and Dremen, 2001; Slovic et al, 2002).



One area of the brain, the anterior cingulate, finds patterns in data.  A sequence of accurate predictors being only two in length can trigger the anterior cingulate to extrapolate that a pattern has been formed.  If corporate earnings are above or below expectations for at least two quarters, then inappropriate extrapolations will often be made.  Several money management firms take advantage of the delayed return to realistic valuation after an extrapolated pattern is broken.



The magnitude of a potential reward activates the brain proportionally to its size.  This increased activation indicates that the person feels both more positive and more aroused by the potential reward.  Investors who anticipate a large reward from an investment will feel happier and more aroused by it.  One danger is that as an investment rises, they may start to check the investment’s progress more frequently.  For most investors, frequent performance feedback leads to lower overall returns (Odean, 2001).  Over-arousal leads to over-trading, and positive feelings contribute to ignoring potential risks.



The probability of a reward occurring has an interesting effect on the brain.  Rewards that occur with 50% probability are more exciting than those that will occur with a 25% or 75% chance.  Rewards of 0% or 100% probability are the least exciting of all.  Humans are most excited to pursue payoffs of 50/50 certainty according to monkey research performed by Fiorillo et al (2003). The Market Wizard Jimmy Rogers, when describing his investment style in Market Wizards, said (to paraphrase): "I just wait ‘til I see the money sitting there, then I walk over and pick it up.”  This statement makes investing sound easy, but it neglects the fact that we are physically bored by certainty – perhaps too bored to push up from our chairs.  Relatively easy profits may be available, but they aren’t as exciting or motivating to investors as the pursuit of risky bets, and that may be why they persist.



A synthesis of the magnitude and probability effects can be performed.  It is now clear that the magnitude effect dominates the probability effect for high-value predicted rewards.  This synthesis explains lottery behavior:  larger potential rewards are more exciting, and this excitement dominates the contrary effect of their low probability.   For example, the low probability of payoff from internet stock investments was irrelevant to investors if they imagined that just one of these investments would be spectacularly profitable. 



There is currently a role for neuroimaging.  Currently our descriptions of brain activity allow new ways of understanding ourselves in terms of very basic emotional and motivational processes.  Demystifying investing and market behavior is only one area to which these findings are relevant.  Fortunately for investors, most experiments into the reward system utilize money as the prototypical reward.  No legal substance, other than money, is found rewarding by all people.  That’s one idea investors can understand. 


It is the emotional balancing act between temptation of profit and fear of loss that makes investing a dangerous game for many people.  In conditions of uncertainty, we often desire to give control to someone else, so we do not feel accountable for any mistakes made. This is perhaps why so many people invest in market-underperforming managed mutual funds (with high annual fees) rather than investing in no-load index funds (the desire to yield control, and accountability, to someone else).  It may also be why many asset managers prefer managing others’ money rather than their own.  It is very stressful to earn money directly for oneself - the brain’s reward system can be thrown into overdrive.


Our work so far provides a basic understanding of valuation, reward processing, and financial disappointment. The greatest value lies within an understanding of what factors lead to dynamic shifts in these processes.  The real value of our work for economists, financiers, investors, and others lies in forecasting what and when new information will lead to reversals of previous expectations, assumptions, and valuations.  This “market timing” work is only just beginning.