Sex or money, the lust is just the same

By Adam Levy

NEW YORK - Late at night, in a basement laboratory at Stanford University, Brian Knutson made a startling discovery: our brains lust after money with the same neurons that they crave sex.

It was May 2004 and Knutson, a professor of neuroscience and psychology at the Californian university, was sending student volunteers through a high-power imaging machine called an fMRI.

Deep inside each subject's head, electrical currents danced through a bundle of neurons about the size and shape of a peanut. Blood was rushing to the brain's pleasure centre as students executed mock stock-and-bond trades. On Knutson's screen, this region of the brain, the core of human desire, flashed canary yellow.

Knutson, 38, concluded that the pleasure of orgasm, the high from cocaine, the rush of buying Google at US$450 a share - the same neural network governs all three. What's more, our primal pleasure circuits can, and often do, override our seat of reason, the brain's frontal cortex, the professor says. In other words, stocks, like sex, sometimes drive us crazy.

Knutson says he knows how heretical his findings are. Wall Street is dedicated to the principle that when it comes to money, logic prevails, that intellect matters in investing. The idea is enshrined in the economic theory of rational expectations, for which Robert Lucas won the Nobel Memorial Prize in Economic Sciences in 1995.

Lucas, a professor of economics at the University of Chicago, maintains that people make economic choices based on all the information available to them and learn from their mistakes. As a result, their expectations about the future are, on average, accurate.

Or so the theory goes. In practice, of course, investors do foolish things all the time. Some gamble away fortunes - losing investments, doubling down when logic tells them to fold or letting winnings ride when the rational person would cash out.

Others seem to have an uncanny knack for knowing when to buy and sell. In the 1970s, Richard Dennis parlayed an initial stake of several thousand dollars into a US$200 million fortune trading commodities in the Chicago futures pits.

In the 1980s, hedge fund icon Paul Tudor Jones made US$80 million by betting against US stocks just before the market crashed.

In the 1990s, billionaire investor George Soros, the man who beat the Bank of England, made US$1 billion in an afternoon by shorting the British pound.

The question that keeps nagging at Knutson is this: why do some traders get rich while others walk away losers? The answer, he says, may lie somewhere in the 96,000km of neural wiring inside our brains.

The results of the Stanford study, published in the September issue of Neuron magazine, have caused a stir among the small group of neuroscientists and psychologists who are mapping the human brain in hopes of understanding investor behaviour.

This controversial field, called neurofinance, may represent the next great frontier on Wall Street, says Daniel Kahneman, who won the 2002 Nobel Prize in economics for his pioneering work in behavioural finance, which fuses classical economic theory and studies of human psychology.

"The brain scientists are the wave of the future in the financial world," Kahneman, 71, says. "If you seek to maximise understanding, whether you're in academia or in the investment community, you'd better pay serious attention to them."

To proponents such as Kahneman, the potential of neurofinance seems virtually limitless.

One day, brain science may help money managers spot shifts in investor sentiment, says David Darst, chief investment strategist at New York-based Morgan Stanley.

Armed with brain scans, psychotherapists may be able to hone traders' natural impulses of fear and greed.

Neuroscientists may even develop psychoactive drugs, or neuroceuticals, that make people better, more-profitable traders, Knutson and other psychologists say.

Look at Prozac. In the space of a few years, Prozac and other drugs have not only revolutionised the treatment of depression but also profoundly changed the way we view the mind. People recognise that chemistry drives their brains, moods and behaviour - and that chemistry can change them.

Similar drugs, ones that improve a trader's decision-making by 20 to 30 per cent, may be just a few years away, says Zack Lynch, managing director of NeuroInsights, a San Francisco-based consulting firm that tracks the US$100 billion neurotechnology industry.

If these neuroceuticals work, they could rock Wall Street. "The whole investment community will be scrambling to get these things," Lynch says.

So far, the hopes and claims of neurofinance have far outpaced its science. Few investment professionals have even heard of the field. Many who have dismiss it as hokum.

"It's the latest malarkey," says Richard Michaud, president of Boston-based New Frontier Advisers.

Michaud, who has a doctorate in mathematics from Boston University, says neurofinance and its forerunner, behavioural finance, have no place on Wall Street.

"I find these so-called disciplines to be more of a marketing tool, a way of taking an ages-old market valuation problem and calling it something space-age," Michaud says. "I doubt it will be fruitful."

Knutson's response: Just wait. "Investors want to beat the market and become better traders," he says. "The first step is to know how the machinery works. The applications to exploit the machinery will soon follow."

People have been trying to explain how financial markets work for more than a century. In 1900, French mathematician Louis Bachelier argued that markets were essentially random.

John Maynard Keynes, in his 1936 work, General Theory of Employment, Interest and Money, likened the sharemarket to beauty contests that ran in newspapers of his day, in which readers were asked to pick the prettiest face.

The key to selecting the winner, Keynes argued, isn't choosing the face you think is the most beautiful but rather anticipating the face other people will pick.

American securities analyst John Burr Williams argued in 1938 that the price of financial assets reflected a measurable intrinsic value, a notion that fits with the value investing approach advocated by Benjamin Graham.

The so-called efficient market hypothesis, popularised by economist Eugene Fama in the 1970s, holds, as Bachelier did, that price changes are random.

In other words, no one can forecast markets accurately.

According to Fama and his followers, technical traders, who believe they can predict prices by examining patterns of price movements, are wasting their time. Chartists can't beat the market. No one can, at least not for long.

For Wall Street, brain science eventually may mean big money, Darst says. Securities firms spend millions of dollars annually researching companies and crunching numbers in an attempt to predict the financial future.

"Meanwhile, we spend peanuts on human psychology," says Darst, author of The Complete Bond Book: A Guide to All Types of Fixed-Income Securities.

"We have to take account of the deep atavistic and visceral traits and instincts that are triggering the buying and selling of securities."

The idea that something other than reason sometimes drives economic decisions is hardly new. Extraordinary Popular Delusions and the Madness of Crowds, written by Charles Mackay in 1841, remains a Wall Street classic to this day.

Mackay examined the history of alchemy, witch hunts, fortune telling and speculative frenzies such as the mania over tulips that gripped Holland in the early 17th century, when the flower bulbs traded at a higher price than gold. His book shows how otherwise intelligent people sometimes succumb to mass idiocy.

What makes a great trader? Alan Greenberg, chairman of the executive committee of Bear Stearns, says the successful ones understand risk, absorb information and make quick, calculated decisions. They also have the self-confidence to take a loss and move on.

Greenberg doesn't buy neuroscientists' claims that such instincts are rooted in our brain. "There's smarts, there's guts and there's instincts," he says. "The other stuff - behavioural, neuro, whatever they call it - is horseshit."


* Terms used in psychology have become ingrained in the language of investing.
* A rush for junk bonds or internet stocks is a "mania".
* An economic collapse is a "depression".
* And the term for one of the vital ingredients of economic prosperity, the naive optimism that prompts people to cast aside their fears despite all experience? Animal spirits.


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