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EC4024 Financial Economics Lecture 19L Neurofinance

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A lecture on behavioural finance and neuroeconomics, called Neurofinance.

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EC4024 Financial Economics Lecture 19L Neurofinance

  1. 1. Neurofinance & behavioural finance Dr Stephen Kinsella/stephen.kinsella@ul.ie/stephenkinsella.net (With slides from Dr. Liam Delaney, UCD)
  2. 2. LAST TIME. Behavioural Finance Basics EMH/AMH/E(U) Theory, Prospect Theory Anomalies: {Winner’s Curse, Loss & Risk Aversion, Jan. Effect}
  3. 3. NOW. Neurofinance & Policy-driven behavioural economics
  4. 4. WHAT I WANT YOU TO LEARN TODAY 1. Overview of Neuroeconomics & Neurofinance 2. Myopic Loss Aversion/Hyperbolic Discounting 3. Policy and Neurofinance/Criticisms
  5. 5. “Neuroeconomics is an emerging transdisciplinary field that uses neuroscientific measurement techniques to identify the neural substrates associated with economic decisions” (Zak, 2004, p.1737)
  6. 6. NEUROECONOMICS Combination of Psychology, Economics and Neuroscience Decisions under certainty and uncertainty: Game Theory using formal economic tasks Neuroscientific Imaging Techniques
  7. 7. NEUROFINANCE Neuroeconomics: Focused on Finance Focused on how people make risky decisions by focusing on the workings of the brain Implications for Financial Markets
  8. 8. Brief Anatomy of the Brain Neurons Synapses Lobes Frontal Temporal Occipital Posterior Subcortical Structures
  9. 9. IMAGING TECHNIQUES • Electroencephalogram (EEG) – Record Electrical Activity on the Scalp – Excellent Temporal Resolution • Functional Magnetic Resonance Imaging – Measures blood flow – Excellent Spatial Resolution • Transcranial Magnetic Stimulation • Positron Emission Topography • Also lesion studies
  10. 10. 3. RATIONALITY AND FINANCIAL BEHAVIOUR Axioms of Choice Under Certainty • Axioms of Choice Under Uncertainty • Contradictions with Experimental Evidence • Money Burning • Physiological Basis for these Contradictions •
  11. 11. ULTIMATUM GAME – Simple Game usually with two players – Two People Decide how to split a sum of money – The first person proposes an amount – The second person can accept or reject – If accept then they split the money as player one has proposed – If reject then both get nothing – Dictator game removes the second step – Let’s play!!
  12. 12. EMOTIONS AND FINANCE • Elster in several papers indicts economics and finance for excluding emotion • Emotional Processing in the Limbic System particularly important for understanding emotion • Emotion alters risk processing and time trade-offs
  13. 13. PETERSON 2005 – NEUROSCIENCE OF INVESTING • Neurons that Carry Rewards from Motivation Centres to Cognitive Centre • Dopamine System – Base Part of the Brain – Limbic System – Frontal “Executive” Areas – “Pleasure Chemicals”
  14. 14. NEUROSCIENCE OF INVESTMENT • Activation of Emotional Reward Systems in the presence of prospective rewards • Can be activated by “non-standard” features • Investors Who Cannot Get Enough • Investors Who are too timid
  15. 15. LOSS AVERSION Fundamental to Behavioural Finance • Kahneman and Tversky Prospect Theory • Sapra and Zak (2008) • Equity Premium Puzzle • Gneezy and Potter (1997) • – Lengthening the time horizon leads people to make “riskier” decisions
  16. 16. NEUROECONOMICS OF TIME DISCOUNTING • Brain areas active when participants make decisions with respect to the future • FMRI Scanning the main imaging paradigm • Testing Hyperbolic Discounting and Dual Decision Making • Affective Decision Making • Visceral Effects
  17. 17. DISCOUNTING Zak (2004) states that one of the major behavioural differences that exists between humans and other animals is the ability to postpone immediate gratification for a future (possibly larger) reward. SMALLER SOONER V LARGER LATER
  18. 18. EXPONENTIAL V HYPERBOLIC DISCOUNTING Exponential Discounting: Exponential discounting implies that a constant preference between rewards should exist over time. Hyperbolic Discounting: Studies show that a clear tendency to discount expected outcomes proportionate to their delays exists and often there is a preference reversal between the immediate and the delayed reward in the period of time just before the reward is due.
  19. 19. EXAMPLE: DISCOUNTING From McClure et al. (2004): A person offered the choice between $10 today and $11 tomorrow may be tempted to choose the immediate option of $10 today. However, a person offered the choice between $10 in a year and $11 in a year and a day may prefer the slightly delayed but larger amount. What causes this inconsistent choice behaviour?
  20. 20. Immediate Rewards (β areas): • Ventral striatum • Medial orbitofrontal cortex • Medial prefrontal cortex
  21. 21. All Intertemporal Choices (σ areas): • Lateral prefrontal (and associated parietal) areas • Visual cortex • Motor areas
  22. 22. POLICY IMPLICATIONS Agreement on a new model of human nature • Communication to Financial Markets • Training and Testing of Traders • “Nudge” • Libertarian Paternalism •
  23. 23. THALER AND SUNSTEIN – LIBERTARIAN PATERNALISM • Libertarian Paternalism • Nudge Nudge • A political philosophy that argues that psychology can influence public policy without coercion • “Libertarian Paternalism” is an oxymoron • Vigorous Debate underway about the nature and scope of these ideas
  24. 24. POLICY PROGRESS SO FAR • Most effort has been placed on interventions aimed to simplify savings mechanisms, reduce procrastination or apply “nudges” • Less work on integrating economics of identity, more complex theories of emotion and more psychological theories of intertemporal choice
  25. 25. SOME RELEVANT PUBLIC POLICY PROBLEMS • Savings too low to fund retirement all around the world • Obesity rates likely to lead to chronic illness levels that will place high health burdens • Consumption patterns arguable unsustainable and inefficient • Psychological health arguably being undermined by rapid social change
  26. 26. EXAMPLE – SAVE MORE TOMORROW • Thaler and Benartzi (2004) • Public Policy Issue: All industrialised countries are aging and savings rates are too low to provide for expected standards of living • Psychological Insight: Individuals discount the future hyperbolically, procrastinate and so on • Solution: Pension mechanisms with payments made from future pay increases
  27. 27. OTHER CURRENT EXAMPLES Opt-Out Mechanisms for Organ Donation • Stick.com – Online Commitment Devices • Financial Simplification Mechanisms • Drug Compliance Regimes • Cognitive Behavioural Therapy Roll Out in the • United Kingdom
  28. 28. BEHAVIOURAL ECONOMICS AND POLITICS • Barack Obama – Reports that his campaign strategy were influenced by Behavioural Economics – Advised by Chicago Economists who lead in behavioural economics
  29. 29. CRITICISMS Student Samples • Small Samples • Potential for Dual-Use • Not Needed – The Mindless Critique • The New Phrenology? •
  30. 30. Friday: Are you sure this is the woman you saw in the post office? • Burns: Absolutely! Who could forget such a monstrous visage? She • has the sloping brow and cranial bumpage of the career criminal. Smithers: Uh, Sir? Phrenology was dismissed as quackery 160 years • ago. Burns: Of course you'd say that...you have the brainpan of a • stagecoach tilter!
  31. 31. READINGS ON BLOG Camerer (2005), Zak (2008) NEXT TIME: LAST LECTURE!

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