What caused the financial crisis? Animal spirits.

What
caused the blind trust in our real estate and mortgage system to
drive real estate prices to dizzying heights? Animal spirits. And
what caused people to lend money to this (largely shadow) bank-
ing system, driving credit expansion beyond comprehension? Yup.
According to economist Robert Shiller, our basic nature is the cause
of our financial booms and downfalls.
But what are these spirits, and how can we get them to stop
messing up? Finding the cause of such behaviors and, even more
appealing, the ability to predict them has long been the Holy Grail
of economic study. Until recently, investigators have been limited
to surmising the reasons by observing behaviors from the outside.
Now, with the development of advanced imaging technologies (such
as functional magnetic resonance imaging, or fMRI) and sophis-
ticated genetic tests, researchers are revealing 3.3 billion years
of evolutionary data resident in the human condition. How asset
managers use this knowledge may well change the way invest-
ment risks are minimized and investment returns are maximized.
Behaviors in life and in markets are the result of many things
social processes, physiological development, genetic predisposi-
tion, and even the color of the room we happen to be in, to name
only a few. Moreover, at the simplest level, behavior is described as
a response to a stimulus. But in a great many conditions, an organ-
ism displays no outward behavior in response to stimuli.
Humansand human biological processesare complex sys-
tems made up of systems of complex systems. For instance, the
rules that govern a heart cell are different from the rules that govern
the heart organ and the rules for the total organism are different
from the rules for the single organ. To understand one system does
not mean you understand the behavior of the whole organism. A
series of articles over the next few issues will report on subsys-
tems. A final article will deal with the whole system.
The first installment of the series looks at biochemical messen-
gers (Part 1) and neural processes (Part 2) that have direct impli-
cations for better understanding how to manage investments and
better understanding ourselves as investors.
CHEMICAL MESSENGERS
Of the thousands of chemical messengers in the
human body, threetestosterone, serotonin,
und oxytocinluve been identied us luving
u diiect impuct on nunciul decisions. Tlese
three also have basic biological functions that
ensuie leultly suivivul. Wlen levels ol tlese
messengers vary from the equilibrium condi-
tion, behaviors vary, and researchers can study
tlis vuiiunce. By ulteiing tle levels und obseiv-
ing behavioral changes, scientists have learned
u lot ubout wlut's belind beluviois. And nun-
ciul decisions uie no exception.
TESTOSTERONE AND TRADING RISK
Testosteione is tle loimone iesponsible loi ieg-
ulating such things as the onset of puberty and
males developing longer and denser bones than
lemules. Moieovei, botl tle nutuiul equilibiium
level of the hormone and variance in testoster-
one levels coiielute witl iisk pioles ol tiudeis.
Wlen Joln Coutes, senioi ieseuicl lellow
in neuioscience und nunce ut tle Univeisity
ol Cumbiidge, begun tiucking tle levels ol tes-
tosterone in high-frequency traders in London,
le expected to nd iising levels ol tle loimone
in tiudeis expeiiencing winning stieuks. Tlis
winner effect, shown in much-replicated stud-
ies of athletes, elevates testosterone in winners
und diminisles testosteione in tle vunquisled.
Accoiding to tle study conducted by Coutes und
his co-authors, successful traders experience a
rise in testosterone, along with characteristics
tlut ulso cun incieuse piotubility, sucl us seuicl
persistence, appetite for risk, and fearlessness in
tle luce ol novelty. Beyond u ceituin ciossovei
point, lowevei, piots uie in dungei becuuse
increased impulsivity and sensation seeking
leud to luimlul iisk tuking. Tlis tiunsloimution
is wlut Coutes desciibed us dog to woll` in lis
book The Hour between Dog and Wolf.
The new science of decisions will
transform how we think about investing
By Cynthia Harrington, CFA Illustration by James Yang
38 CFA Institute Magazine Jan/Feb 2013
INVESTOR
BIOLOGICAL THE
Jan/Feb 2013 CFA Institute Magazine 39
Coutes biouglt ieul-lile expeiience to tle
study, having traded derivatives at Goldman
Sucls und Meiiill Lyncl in New Yoik City. His
own experiences and observations formed some
ol tle lypotleses le undeitook to study. Accoid-
ing to the conclusions in his research, this tran-
sition liom ieusonuble to iubid, even il conned
to u smull numbei ol people, could cuuse nun-
cial markets to deviate from the predictions of
iutionul cloice tleoiy. But we luve to look ut
nutuie und nuituie,` udds Coutes. Tlis is not
just a momentary reaction but perhaps a funda-
mental difference in which some people with a
higher degree of testosterone production natu-
iully luve u liglei iisk-tuking impulse.`
Even ngei size lus u stoiy to tell. Tle 2D:4D
iutio (tle iutio ol tle lengtl ol tle index ngei
to tle lengtl ol tle iing ngei) coiielutes sig-
nicuntly witl tle numbei ol iisky positions
estublisled by tiudeis. Tle digit iutio is used
as a kind of shorthand measure for the equilib-
rium level of testosterone in a male, based on
the theory that some males have higher expo-
suie to undiogens in uteio. Coutes's ieseuicl
estublisled tle connection umong tiudeis.
In investing, lowevei, one veiy piotuble
duy does not u tiuck iecoid muke. Risk pielei-
ences cun uctuute liom iubid to extiemely iisk
uveise ovei time. Coutes exumined wletlei evi-
dence of returns was commensurate with the
testosteione-diiven iisk pieleiences. Altlougl
the jury is still out about the exact correlation
of returns and testosterone, there is evidence
tlut Sluipe iutios incieuse ovei time. We did
nd tlis elite gioup ol tiudeis tlut pioduced
ever-increasing Sharpe ratios, with many above
1 tliougl tle nunciul ciisis,` suys Coutes. Tlis
provides one of the few documented and testable
clullenges to tle elcient muiket lypotlesis.`
It also provides one of the two solid, prac-
ticul upplicutions ol lis ieseuicl. Fiist, to nd
out whether an employee has a trading skill
worth paying for, employers can plot a rising
Sharpe ratio against the number of years trad-
ing. Second, employeis slould not increase
ullocutions to winning tiudeis. Unloitunutely,
banks are amplifying the shifts in risk prefer-
ences by upping allocations for winning trad-
eis,` le suys. We luve to be leuning uguinst
the physiological shift in risk preferences and,
like an athlete with a physical trait, train and
munuge loi gieutei ellectiveness.`
FROM CUDDLING TO CUTTING
Unlike testosteione, wlicl is ussociuted witl
males, oxytocin is discussed primarily in relation
to lemules. Tlis clemicul messengei ucts botl
us u loimone und sometimes us u neuiopeptide.
It is what bonds mother to child, and the level
of oxytocin surges before and after childbirth
to deaden the pain that could interrupt that
bonding leeling. Wlen ieleused by u stimulus,
such as seeing a loved one, oxytocin acts on
the receptors in many brain regions, including
two ol tlose ieluting to memoiy und emotions.
Witl elevuted levels ol oxytocin, botl men und
women experience diminished memory perfor-
mance and have an impulse to behaviors that
expiess tiust, coopeiution, und geneiosity.
Tle sume ellect tlut bonds motlei und clild
seems to be tle busis ol bonding in ull gioups.
And wlen extiu doses ol oxytocin uie udmin-
istered in the lab, this bonding turns behav-
iois liom cuddly to cutting. Study subjects still
bonded but only with people with whom they
lud un ulliution. Tlis nding lus deep impli-
cations for investing because the bonding mech-
anism could be the physiological drive behind
leiding beluviois.
In one study, subjects were presented with
u scenuiio ol lile oi deutl. Tley contiolled u
switch that would divert a runaway train, saving
ve unsuspecting people but killing one on tle
otlei tiuck. Tlis lumiliui veision ol tle Ulti-
mutum Gume` usuully pioves utility tleoiy:
Most subjects cloose to suve tle luigei numbei,
und ve is pieleiuble to one. But un intiunusul
slot ol oxytocin clunges tle outcome. Wlen
the one person on the other track had a name
familiar to the test subject, they chose not to
diveit tle tiuin uwuy liom tle unlumiliui ve
people. Tlese iesults slow tlut oxytocin stim-
ulutes in-gioup conloimity,` suys Miiie Stullen
ol tle Dondeis Institute loi Biuin, Cognition und
Beluvioui ut Rudboud Univeisity Nijmegen in
tle Netleilunds. In sloit, oxytocin's ellects on
sociul beluvioi uie context dependent.`
Could tlis desiie to identily witl un in
group be one factor in herding behavior related
to investments? Perhaps the bonding feeling
of being in a group of winners was behind the
2010 piepondeiunce ol Apple stock ut luige
ledge lunds oi tle ocking to quunt stiutegies
(the subsequent exodus from which was blamed
loi tle liquidity ciuncl in August 2007). We
know that people often conform to others with
wlom tley ussociute,` suys Stullen. Howevei,
whether oxytocins effects on in-group favorit-
ism uie sulciently poweilul to uctuully inu-
ence individuals subjective preferences, and
thus stimulate in-group conformity, remained
until now un impoitunt open question.`
HIGH ANXIETY, LOW SEROTONIN
A tliid clemicul messengei, tle neuiotiunsmit-
ter serotonin, regulates equilibrium functions,
SUBJECTS
WERE PRE-
SENTED WITH
A SCENARIO
OF LIFE OR
DEATH. THEY
CONTROLLED A
SWITCH THAT
WOULD DIVERT
A RUNAWAY
TRAIN, SAVING
FIVE UNSUS-
PECTING PEO-
PLE BUT KILLING
ONE ON THE
OTHER TRACK.
40 CFA Institute Magazine Jan/Feb 2013
sucl us bieutling. Relutive incieuses oi decieuses
in the compound can affect the level of anxiety
in u peison. Botl tle equilibiium level ol seio-
tonin and periodic changes in serotonin levels
diumuticully ullect nunciul decisions.
Pluyeis in u veision ol tle Ultimutum Gume
culled Ultimutum Gume Linked` becume ovei-
whelmingly uncooperative after drinking con-
coctions designed to reduce the levels of sero-
tonin in tleii bodies. In one veision ol tle gume,
one player in a dyad is given a sum of money
and instructed to split the sum with the other
pluyei. Noimully, ubout lull ol olleis umounting
to less tlun 30% ol tle totul sum uie iejected,
despite the fact that to reject means the sub-
ject gets notling. Subjects witl depleted seio-
tonin lud u iejection iute ol 80%. Reseuicleis
concluded that missing the moderating effect
of normal serotonin levels changed the percep-
tions of subjects, who thus impulsively rejected
what might have previously been considered to
be ucceptuble olleis.
Wlut exuctly is going on witl dilleiing levels
of serotonin is the subject of a multipronged
uppioucl by Cumeliu Kulnen, ussociute pio-
lessoi ol nunce ut tle Kellogg Sclool ol Mun-
ugement ut Noitlwestein Univeisity. Kulnen
wants to know more than just what happens to
behaviors as a result of the presence or activity
ol tlis clemicul. Woiking in tle vein ol moie
classical neuroeconomists, she seeks causes of
beluvioi in tle biuin. Il emotions muttei loi
nunciul decision muking, let's see low tley
muttei,` sle suys. Let's piove once und loi ull
that brain areas are responsible for these emo-
tional states and are in play when people make
nunciul decisions.`
As it tuins out, seiotonin ullects tle biuin in
ways associated with differences in risk prefer-
ences among people, and the study of serotonin
also revealed a genetic link to risk-seeking or
iisk-uvoidunce beluviois. People witl sloit-ullele
versions of the serotonin receptor gene invest in
fewer equities, are passive investors, and (when
enguged in investing) cloose tiunsuctions tlut
uie simple iutlei tlun complex. (An ullele is un
un ulteinutive loim ol u gene locuted in u specic
pluce on u puiticului cliomosome.) People witl
long ulleles exlibit tle opposite pieleiences. Even
though there was little difference in education
levels, intelligence levels, overall wealth, or the
amount of assets, the risk preferences between
tle two gioups weie distinct. Queiies ubout
the emotional makeup of test subjects further
extended tle dilleiences between tle gioups.
Tle gene ellect seems to be ieluted to psyclo-
logical, emotion-driven differences between
those carrying the short and the long alleles,
suys Kulnen. Sloit-ullele cuiiieis luve liglei
scores on neuroticism and negative affect and
lower scores on positive affect, suggesting that
these individuals are ex ante focused on the neg-
utive potentiul outcomes.`
But u piedictive cuusul ielutionslip still
iemuined to be lound. Putting tle subjects in
u lunctionul MRI, Kulnen und lei co-uutlois
determined that that brain activity of short-
versus long-allele subjects also correlated
with the previously established understand-
ing ol biuin iegions. Tley locused on two biuin
regions, the anterior insula (involved with gen-
erating negative emotional reactions, such as
unxiety oi disgust, und tiucking outcome iisk)
and the nucleus accumbens (responsible for
excitement or joy and seeking both reward
und iisk). As expected, tle unxiety-meusui-
ing, risk-avoiding anterior insula activated in
short-allele people and the reward-seeking
nucleus accumbens lit up for long-allele sub-
jects. Tlis slows tlut it is impoitunt loi tlose
who want to encourage an investor to invest in
risky assets to make a very clear case for the
upside,` suys Kulnen. Since tlis genetic link
causes a misperception, its possible to balance
tlut oll und clunge tle peiception.`
So, what are professional investors to do with
all this new knowledge? One might imagine a
daily testing regime, accompanied by a mood
cocktail, to keep the chemistry in proper bal-
unce. Peilups u duily tiucking ol tiudeis' plys-
iology could be used to measure trading prof-
its in a way that combines big data with the
uppioucl desciibed by uutloi Micluel Lewis
in his book Moneyball. Coutes suggests u stull
munugement solution us well: Put moie lemules
on tle tiuding ooi to dumpen tle iun to iisky
tiudes.
Big-dutu metlods need big models, und uccu-
rate models demand a better understanding of
neuiul decision-muking piocesses. To tlis end,
experts in computational cognitive science are
studying the layers and layers of processes and
tleii mutlemuticul components.
NEURAL PROCESSES
Altlougl we luve neuions tliouglout oui
bodies, tle king ol neuiul uctivity is tle biuin.
Witl between 10 billion und 100 billion neu-
rons, the brain accounts for the majority of
tle body's electiicul uctivity; tle 100 million
gut putlwuys come in u distunt second. Study
ol tle biuin is iupidly evolving. In tle time it
takes to read this article, a mountain of new
ndings into tle pust und piesent ol tle biuin
will be completed.
Jan/Feb 2013 CFA Institute Magazine 41
A prevailing theory about the brain is that
the evolutionary process has brought the organs
stiuctuies und lunctions to u meusuie ol tness.
Yet, tle inteisection ol neuiology und nunce
seems to reveal some quirks that skew the per-
ception of risk and reward processing that leads
to pooi nunciul iesults.
All lumuns live in unceituinty, but nun-
cial decision makers are in a heightened state
ol unceituinty. So, u new oppoitunity in tle
quest to create alpha comes from the expand-
ing knowledge of riskreward processing, how
humans choose to exhibit behaviors or inhibit
them, and the neural correlates of social versus
piivute decision muking.
BEYOND THE MONKEY BRAIN
Colluboiutions between biologists und nun-
ciul ucudemics uie iecent. Less tlun u decude
ago, Peter Bossaerts, a professor of experimen-
tul nunce, needed to undeistund tle mutl
behind the brains reward-processing mecha-
nisms. Ovei dinnei witl neuioscientists, le got
unsweis. In uddition, le usked tlem low tley
ieucled conclusions ubout iisk piocessing. We
don't look ut iisk` wus tle unswei.
Because the trade-off between risk and return
forms the basis of investment decisions, Peter
Bossueits' teum ut tle Cultecl Luboiutoiy loi
Experimental Finance has since done pioneer-
ing work on neural processing of both risk and
ietuin. Along tle wuy, tley've ulso discoveied
moie. Bossueits' teum wus tle ist to identily
the neural signals behind the magnitude of the
eiiois in piedicting iisks und iewuids.
Risk-prediction errors were unknown until
2008 because monkeys, the previous test sub-
jects, lack the neurons in which the human errors
occui. Tle lumun neuiul wiiing ullows us to
assess risk in an advanced way, which might be a
key distinction between oui species und otleis.
As with serotonin studies, research on risk
processing focuses on the brain region called
tle unteiioi insulu. It is geneiully consideied
the brain location in which emotions are trans-
luted into tle mentul stute ol leelings. Looking
at neural activity under experimental condi-
tions yielded sometling suipiising und vuluuble.
Heie, we lound tlese cool mutlemuticul signuls
in what we think of as a hot emotional region,
suys Bossueits. Tlis gives us tle meuns to do
a quantitative analysis of uncertainty-induced
neuiul uctivution.`
To i nduce conditions ol unceitui nt y,
Bossaerts team designs experiments around
games, observes behavior, and measures brain
uctivity. We wutcl decisions us tley luppen in
trust games, in games in which subjects trade
pennies,` expluins Bossueits. Tlese uie cunon-
ical examples of all social interchanges, and
tlese expeiiments uie tlen ieective ol low
we decide in ieul lile.`
Setting tle iesults in ieul lile is impoitunt
to tlis teum. Tley luve lound signicunt dil-
ferences in neural responses to intentional risk
versus non-intentional or naturally occurring
iisks. Intentionul, oi stiutegic, unceituinty comes
in response to risks created by goal-directed
opponents looking to win u iewuid. Non-inten-
tional risks include weather conditions, water
pipe eruptions, slipping on ice, or crises that
occur naturally because of the complexity of
linunciul muikets. We uie linding tlut tle
biuin lus stiong evolutionuiy tness in iecog-
nizing sociul iisks ovei puie nunciul iisks,` suys
Bossueits. Tle complexity ol tle OTC muiket
wlicl by denition is opuque, wleie A nds B
und B nds C but A doesn't know Cis u nun-
ciul iisk tlut tle biuin piocesses dilleiently.`
Tle unteiioi insulu biuin iegion muy become
u lumiliui topic to nunciul piolessionuls. Tlis
interesting area handles complex emotional and
sociul dutu signuls. Considei, loi exumple, puin
uctivution. Il we'ie in puin, tle inteiioi poste-
rior section activates; if we see someone else
in puin, tle liontul uieu is enguged. Tle unte-
rior insula is where we process empathy for
others in pain, our own feelings of awareness
and consciousness, and the awareness of our
biologicul body stiuctuie. It is tle iegion tlut
malfunctions in antisocial personality disor-
ders; people with the disorder do not have the
uctivution liom sociul signuls.
Wlut points to tle lutuie ol tle ieseuicl,
lowevei, uie tlese mutlemuticul signulsevi-
dence of hard-wiring in the brain, which sug-
gests the possibility of constructing models for
luitlei study. Imugine u lutuie witl ussess-
ment tests for portfolio managers or traders that
measure the degree of risk- and reward-predic-
tion eiiois tley miglt muke. Bossueits's teum
is headed toward creating applications of the
decision science. Tle wiied signuls meun tlut
while the person might get new or novel inputs,
the processing algorithm is the same; thus, the
eiiois [uie tle sume|,` le suys. Humuns in gen-
eiul cun't live well witl umbiguity.`
WE FOUND THESE COOL MATHEMATICAL SIGNALS
IN WHAT WE THINK OF AS A HOT EMOTIONAL
REGION. THIS GIVES US THE MEANS TO DO
A QUANTITATIVE ANALYSIS OF UNCERTAINTY-
INDUCED NEURAL ACTIVATION.
42 CFA Institute Magazine Jan/Feb 2013
MEET THE BASAL GANGLIA
Modeling biuin lunctions is tle diiving loice
belind Micluel Fiunk's study ol neuiocompu-
tution. Witl degiees in electiicul engineeiing
und u PlD in neuioscience und psyclology, le
has applied all the knowledge from his studies
in doing award-winning research on the basal
gungliu. His goul is to undeistund tle cloices we
muke to uct oi not uct, to exlibit u beluvioi oi not.
On average, the human brain has an esti-
muted 10
15
synupses opeiuting ut ubout 10
impulses pei second. Despite tlis complex-
ity, we usually display a relatively controlled
demeunoi. Studying tle cloice to uct oi not uct
can provide major advances in understanding
low tle biuin woiks.
Knowing tlut Puikinson's diseuse, witl its
symptoms of jerks and shakes and inability to
walk, was a malfunction of the basal ganglia,
Fiunk tlouglt tlis uieu seemed like u good
pluce to stuit. Tle ciicuitiy ol tle busul gungliu
is intimately connected with the brains cortical
iegions und liglei cognitive lunctions. Wlen
we understand how the mind works, we will
understand more than behaviors alone in that
we will understand behavioral preferences,
expluins Fiunk.
To tlut end, Fiunk lus identied two inde-
pendent putlwuys. Resident in tlis iegion ol
uction potentiul uie wlut Fiunk culls tle Go oi
No-Go` putlwuys. In one study, le udministeied
pharmacological substances to see how inter-
ventions in those pathways might change behav-
iois. He looked ut tle iewuid impulses in cog-
nition by administering cabergoline, prescribed
for women to prompt production of breast milk,
and haloperidol, used to treat psychotic disor-
ders and dysfunctional motor control problems,
sucl us lubituul tics. I wus suipiised to see tlut
the behaviors were as impacted as strongly as
tley weie,` le suys. All kinds ol beluviois uie
sensitive to clunges in tlis iegion.`
As witl tle lindings loi buse levels ol
serotonin and testosterone, different people
iesponded dilleiently to tle diugs. Tle diugs
affect dopamine [neurotransmitter associated
with reward processing], and the effect is dif-
leient depending on tle peison,` suys Fiunk.
Some do worse on tests after the administra-
tion ol tle diug, und some do bettei.`
Modeling tlese putlwuys is cieuting tle busis
for future study, especially for understanding
leuining piocesses. As it tuins out, tle Go putl-
ways learn differently from positive feedback
und negutive leedbuck tlun tle No-Go putl-
wuys. Moieovei, eucl peison lus u dominunt
style: Some uie positive leuineis, und otleis,
negutive leuineis.
Wlut becomes ieully inteiesting is tlut some
pathways learn from both positive and negative
feedback, and these integrated pathways learn
more than those that have the preference for
eitlei positive oi negutive leedbuck. Lots ol
the work shows how we process the good and
bad outcomes to actions that we are not aware
tlut we uie piocessing,` suys Fiunk.
Tlese models uie constuntly being upduted
und ievised. No model cun cuptuie ull tle dutu,
und Fiunk notes tlut lis omits seveiul molecu-
lar and systems-level effects that are undoubt-
edly ielevunt.` Still, tlese metlods ol investi-
gation are more advanced than the old ways of
diagramming brain function and thus speed up
tle undeistunding ol biuin lunction. It is dil-
cult to model with the thing that is being mod-
eled,` suys Fiunk. But bused on tlese simple
learning processes, we are ready in some ways
to go to the next steps of understanding cogni-
tive piocesses in oui duily lives.`
ONE-UPMANSHIP
Tle dilleiences between decisions mude in u
social setting and decisions made in private
luve gieut ielevunce to nunciul piolessionuls.
Most ol tle woik ol nunciul decisions is in u
social context, whether as part of a team or in
udvising clients. Wlen one teum ol ieseuicl-
ers set out to study differences in both behav-
iors and neural coordinates, they found impor-
tunt distinctions.
Foi one, we tuke u lot longeiovei twice us
longto decide on a transaction when playing
uguinst unotlei pluyei. Foi unotlei, tle iewuid
leuining clunges. In subsequent iounds, pluy-
eis seek not only to muximize iewuids but
also to gain relatively more than a subject with
wlicl tley compuie outcomes. Diuwing oll tle
research into neural coordinates of envy and
pride, researchers discovered much about how
we decide to keep up witl otleis.
How outcomes ol counteiluctuul (oi ctive)
options not chosen heighten risky behaviors,
especially in competitive environments, has par-
ticului signicunce loi investing, uccoiding to
economist Aldo Rusticlini, one ol tle uutlois
ol tle study Mediul Pieliontul Coitex und Stii-
utum Mediute tle Inuence ol Sociul Compuii-
son on tle Decision Piocess. `
Counteiluctuul ieusoning is using inloimu-
tion about what one could have gotten from a
cloice umong nunciul iewuids,` suys Rusticl-
ini. Tlis ieusoning piocess is one in wlicl we
evaluate our choices, and that is the teaching
tool loi bettei lutuie cloices.`
In tleii study, Rusticlini und lis lellow
researchers presented subjects with a series
SUBJECTS
EXPERIENCED
REGRET OVER
THEIR OWN
UNCHOSEN
OPTIONS WITH
SUPERIOR
OUTCOMES.
IN THE SOCIAL
COMPARISON
TRIALS, THAT
TRANSLATED
INTO RISKIER
BEHAVIORS.
ol lotteiy cloices. Hull compuied tleii out-
comes witl tle outcomes tley ludn't closen.
Tle otlei lull compuied tleii outcomes witl
tlose ol unotlei pluyei. In tle compuiison
trials, multiple brain regions associated with
social rewards, positive social comparison,
social ranking, and the emotional reactions
to the misfortune of previously envied people
weie enguged. Subjects expeiienced iegiet ovei
their own unchosen options with superior out-
comes,` suys Rusticlini. In tle sociul compui-
ison trials, that translated into riskier behav-
iois in lutuie iounds in tle study.`
In all trials, examining the roles of pride,
regret, and envy yielded the main insights from
tle study. Tle signuls liom tlese emotions
prompted learning about future choices in situ-
utions ol unceituinty. All tlese emotions piompt
counterfactual thinking, or reviewing the out-
comes ol pust uctions. Tle key point leie is to
see that while were aware of these emotions,
were taking into account the information about
unclosen options,` suys Rusticlini. Tle moment
it becomes pathological is when that learning
sluts down und tle emotionul uspect tukes ovei.`
An impoitunt uspect ol tle ndings is tle iel-
utive iesponse to guins und losses. Risky beluv-
iors increased more in the search for social
guins tlun in tle seuicl loi sociul losses. Biuin
activation followed, with larger activations for
ielutive guins tlun loi losses. Evidently, it's
important not just to choose well but also to
win ovei unotlei. Tlinking ubout diiect uppli-
cations of this knowledge, researchers point to
setting u wuge stiuctuie in u im, to tle luct
tlut piizes olten woik bettei tlun wuges us
motivational compensation, and to proposals
loi tux policy tlut exes witl un economic cycle.
Tlis study ulso ieveuled unotlei impoitunt
implication of social responses for investment
decision mukeis. One iegion ol tle biuin lus
been identied us being ussociuted witl tle
perception, or misperception, of the intent of
unotlei's uctions. Teimed mentulizing,` tlis
activity is our subconscious essentially making
sense of the behaviors of another by reading his
oi lei mind. Could it be tlut un elite gioup ol
traders has learned to do this more accurately
and thus has learned to create alpha over time?
To dute, ieseuicleis luve not deteimined low
the brain calculates this mind reading, but as
this processing math is understood, this region
may be important in understanding invest-
ment decisions.
In thinking about the applicability of these
ndings to investment munugement oi counsel,
a component of the study design is important
to note. Tle cloice stiuctuie, being u seiies ol
independent lotteries, was not about allocation
ol scuice iesouices. Tle sociul compuiisons weie
just thatthe review of outcomes of another
subjectbut the results of those outcomes had
no diiect impuct on tle outcomes ol tle ist
subject's well-being. In tle woids ol Rusticl-
ini, Tle distoition ellects on decision output
from social comparisons and the underlying
neuiul uctivity is u luitlei nuil in tle coln ol
tle centiul concept ol clussicul utility lunction.`
Its clear that the brain has quirks that dont
follow the tenets of rational choice, on which
so mucl ol cuiient decision models uie bused.
Studies witl new ndings uie being publisled
ull tle time. As we muddle tliougl in tlis
transition phase, investors at least can take
some comfort from the fact that new models
and more precise data inputs are both on fast
tracks to providing realistic bases for invest-
ment decisions.
Cynthia Harrington, CFA, is principal at Cynthia
Harrington & Associates, a Los Angeles-based firm
that provides executive coaching for investment
professionals.
Jan/Feb 2013 CFA Institute Magazine 43