Warren Buffett once suggested that investors should try to “be fearful when others are greedy and be greedy only when others are fearful.”
But according to a new study by Caltech and Virginia Tech behavioural economists, only certain people’s brains are capable of acting on this advice.
The researchers looked at the brain activity and behaviour of people trading in experimental markets where price bubbles formed, using an fMRI scanner to track responses.
They found that only “wise” traders received an early “warning signal” from their brains, causing them to feel uncomfortable and urging them to sell.
The wiser traders had more intense activity in the insular cortex, which is associated with risk aversion — it’s often activated when a person smells something rank. The much more common brain pattern the researchers found was one that made traders behave in a greedy way, buying aggressively during a bubble and even after its peak. These traders had much greater activity in the nucleus accumbens, or NAcc, which is associated with reward processing.
Here’s the brain activity chart: The high earners, in green, saw significantly more insula activity as a peak approached. Meanwhile, the poorly performing traders’ brains’ regulation areas basically shut down.
And here’s the trading activity chart. The high earners, in green, curbed their trading activity significantly as they sensed peak pricing approach, then bought into the dip once it passed. The bad traders kept buying throughout the peak.
“Seeing what’s going on in people’s brains when they are trading suggests that Buffett was right on target,” Colin Camerer, the Robert Kirby Professor of Behavioural Economics at Caltech, said in a university release.
“The high-earning traders are the most interesting people to us. Emotionally, they have to do something really hard: sell into a rising market. We thought that something must be going on in their brains that gives them an early warning signal.”
“”The prices were still going up at that time, so they couldn’t be making pessimistic predictions just based on the recent price trend,” Camerer said. “We think this is a real warning signal.”
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