Market bubbles that lead to financial crashes may be self-made because of instinctive biological mechanisms in traders’ brains that lead them to try and predict how others behave, according to a new study by David Eccles School of Business Finance professor Peter Bossaerts and his co-authors at the California Institute of Technology.
The research offers the first insight into the processes in the brain that underpin financial decisions and behavior leading to the formation of market bubbles. Publication of the study coincides with the five year anniversary of the infamous collapse of the Lehman Brothers investment bank in 2008.
A ‘bubble’ happens when active trading of a commodity or asset reaches prices that are considerably higher than its intrinsic value, usually followed by a market crash. The boom and bust of the U.S. ‘dot com’ sector and the crash in the United Kingdom housing market are recent examples that resulted in billions of pounds in financial losses. Although bubbles have been intensely investigated in economics, the reasons why they arise and crash are not well understood and we know little about the biology of financial decision behaviour.
Researchers at the California Institute of Technology investigated the problem by bringing together expertise in experimental finance and neuroscience to look at the brain activity and behaviour of student volunteers as they traded shares within a staged financial market.
The researchers used functional Magnetic Resonance Imaging (fMRI), a technique to measure the flow of blood in the brain as an indication of activity, to map participants’ brain activity as they traded within the experimental market.