In an ongoing effort to lay the theoretical groundwork for our contention that markets are non-linear and that human emotion plays an important role in determining asset prices, we have been occasionally posting articles on this subject. Below is another in the series: this one on the various theories of human emotion. Brevity requires us to vastly summarize a massive body of research and literature in order to make our point about the role that emotion plays in human decision making. To this end, we'll simply skim several of the theories that underlie the physiology and nature of emotion in human development.
Evolutionary biology has offered a number of different competing theories on human emotion. Early on, theorists posited that emotions represent a breakdown in the smoothly functioning cognitive processes like rational planning. The implication was that emotions were an error of the mind. Most theorists now believe that emotions are not at all aberrations but rather adaptations whose purpose is to solve basic environmental challenges facing humans: reproduction, survival, etc. Most theorists believe that there is a physiological component to emotions and indeed that physiology has changed over time in an adaptive and evolutionary manner. But what purpose do emotions serve? Why do humans have them at all? Evolutionary psychologists believe that emotions act as a filtering mechanism. Insofar as humans are faced with a massively large number of potential optimal choices (for mating, for food acquisition, for shelter, for social strategies, etc.), a purely rational decision making process would be computationally impossible. Add to this another layer of complexity: the number of potential consequences of those choices is infinite.
Faced with both a massive number of optimal choices and a literally infinite number of potential consequences stemming from those choices, a purely rational mind would find it impossible to make any decision at all. Theorists now believe that the role of emotions is to act as an extraordinarily efficient filter: eliminating entire classes of choice and consequence a priori. Antonio Damasio, in a large number of neurological studies, has amassed considerable evidence that supports this claim. He has found that patients who suffered damage to prefrontal or somatosensory portions of their brains had a diminished capacity to make intelligent and practical decisions owing to the fact that they could not experience emotion.
Though academics like Damasio have asserted that emotion plays a critical role in making rational decisions, it has long been known too that emotions can also be the source of self-deception. Emotions, though they may be essential to rational decision making, can also be the greatest source for irrational decision making and self-deception as well. This dual-role, as both an enabler of rational decision making and a hindrance to it, is currently the focus of intense study. Patricia Greenspan is foremost in this effort and as an extension has recently turned her attention toward understanding the role that emotion plays in developing strategies for social interaction and for the application of game theory within competitive environments. Lastly, Aaron Sloman has more recently argued that the human mind should be understood within the context of the physiological architecture of the brain, with some complex interrelationships formed between higher order parts of the brain (the cortex) and lower level "sub-systems", the whole of which is to produce both raw emotions that served humans well from a survival standpoint as well as those more evolved emotions that relate to human response to art, literature, social intercourse, etc.
The academic literature on the subject is both broad and deep and interested readers will, we are sure, find much to chew on in this area. But for purposes of brevity, we can conclude that current thinking in the field comes down to this:
1. Emotions are both conscious and unconscious phenomenon
2. They can be both antagonists and facilitators of rationality
3. They result from a complex interplay between different parts of the brain's physiology.
That humans are emotional is, of course, self evident. How that emotion plays a role, and how large a role it indeed does play, is what is important for investors to understand. We encourage readers to delve deeper into this area to gain a better understanding of how emotion affects asset markets and the price discovery mechanism.
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