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Will Brain Science Ever Explain Why Traders Make $2 Billion Mistakes?


When Jamie Dimon named the reasons for recent losses at his firm, he neglected to mention one considerable factor: neurology.

People may behave unreasonably and even self-destructively in other arenas, but when it comes to the market, clinical rationality wins the day, right?

Well, we all know better than that. In fact, one of the main difficulties in using game theory to model market uncertainty is that game theory presupposes that everyone in the game is behaving, for want of a more trenchant word, rationally. That premise has repeatedly been shown to be shaky at best.

And we're not talking about "reason" as some complicated Cartesian principle here. Just the simple likelihood that, once you've understood what you need to do to hang onto the greatest bulk of your wealth for the longest period, you will predictably do that thing 10 times out of 10.

If that were the case, we wouldn't be reading the headlines this week about more than $2 billion in losses at JPMorgan Chase (JPM). The bank recently disclosed that in the last several weeks it had lost that amount in a portfolio of credit investments managed by the company's Chief Investment Office. "We took far too much risk, the strategy that we had was barely vetted, it was badly monitored. It should never have happened," JPMorgan Chase CEO Jamie Dimon said in a statement. He also confessed to "errors, sloppiness, and bad judgment" on the part of the bank's traders.

The financial press has reported that JPMorgan's losses originated with the bank's chief investment office, where a trader nicknamed the "London Whale" is thought to have taken major positions in credit-default swaps.

But what makes someone like the supposed "London Whale" -- identified as Bruno Iksil -- tick? Why is it that so many investors and traders seem to behave in ways that, in retrospect, even they would agree made no sense? What exactly is going on? Is it some kind of fiscal corollary to Freud's concept of the death drive?

While it might be tempting to pinpoint trading itself as the self-selecting precondition for defeatist behavior -- the market is unstable, thus appealing to that which is most unstable in us -- this theory won't cover the whole story. Investor behavior is much more complex.

The woeful tendency to sell low and buy high, for instance, even has its own name: Behavioral economists Meir Statman and Hersh Shefrin coined it the "disposition effect," the dread of ending up, even briefly, with less than we started with, and the irrational insistence on holding out just a bit longer even as we lose just a bit more. (Thanks to the disposition effect, investors tend not to see their own losses and therefore don't recognize them as such, while they do tend to see their gains.)

Even the mentality of gambling as an addiction -- specifically, the mental physiology of it -- may be similar to that of making illogical investment decisions. So theorize a segment of behavioral economists, known as "neuroeconomists," who've been researching why the investing choices people make with their money, even -- or especially -- when such people are positioned to know better, can be so bafflingly wrong. Here are a few of the most provocative of their findings.

Less Fear Equals Better Trading
The first to clearly identify "loss aversion" -- not just the yen we all have to not lose, but more tellingly, a desire to not lose so acute that it trumps the desire to gain, and by a lot -- were the noted psychologists Amos Tversky and Daniel Kahneman. Their body of work from the 1980s and '90s got another surge of recognition recently as the theoretical underpinning for the draft-pick techniques dramatized in the movie Moneyball.

Decades later, behavioral economists are attempting to map out more specifically the origins of this tendency. For instance, Colin Camerer, the Robert Kirby Professor of Behavioral Finance and Economics at the California Institute of Technology, and his colleagues have identified what they think is the neural seat of this aversion:

Using functional brain imaging, we show that the level of ambiguity in choices correlates positively with activation in the amygdala and orbitofrontal cortex, and negatively with a striatal system. Moreover, striatal activity correlates positively with expected reward. Neurological subjects with orbitofrontal lesions were insensitive to the level of ambiguity and risk in behavioral choices.

In layman's terms, the researchers found that people with injuries in the parts of the brain that affected their ability to process emotions made slightly better investing decisions than others, suggesting that less emotional and less fearful people might make better investors. New Yorker writer John Cassidy described Camerer's brain damage experiment in his magazine piece "Mind Games."

Each of the patients had a lesion in one of three regions of the brain that are central to the processing of emotions: the amygdala, the orbitofrontal cortex, or the right insular cortex. The researchers presented the patients with a series of fifty-fifty gambles, in which they stood to win a dollar-fifty or lose a dollar. This is the type of gamble that people often reject, owing to loss aversion, but the patients with lesions accepted the bets more than eighty per cent of the time, and they ended up making significantly more money than a control group made up of people who had no brain damage.

"Clearly, having frontal damage undermines the over-all quality of decision-making," Loewenstein, Camerer, and Drazen Prelec, a psychologist at M.I.T.'s Sloan School of Management, wrote in the March, 2005, issue of the Journal of Economic Literature. "But there are situations in which frontal damage can result in superior decisions."
Basing their results on functional MRIs looking at the same portions of the brain -- amygdala and striatum -- Camerer and another group of researchers have also found that using techniques to regulate emotion visibly reduced a person's aversion to loss. At least theoretically, this reduction in loss aversion might in turn help investors make calmer, more rational decisions.

Brain Behaves Differently When Taking a Risk Versus Avoiding Failure
Another researcher who's spent nearly a decade mapping out possible physical locations for psychic inconsistencies is Brian Knutson, associate professor of psychology and neuroscience at Stanford University. Over a period of years in different settings, Knutson, using functional MRIs, singled out the mesial prefrontal cortex (which plays a role in cognitive decision making) and nucleus accumbens (activated by rewards and pleasure, but also aggression and fear) as loci of behavioral anomalies.

In a 2005 article, "The Neural Basis of Financial Risk Taking," he noted:
We characterized two types of deviations from the optimal investment strategy of a rational risk-neutral agent as risk-seeking mistakes and risk-aversion mistakes. Nucleus accumbens activation preceded risky choices as well as risk-seeking mistakes, while anterior insula activation preceded riskless choices as well as risk-aversion mistakes. These findings suggest that distinct neural circuits linked to anticipatory affect promote different types of financial choices and indicate that excessive activation of these circuits may lead to investing mistakes.

In other words, the researcher found that one brain pathway -- the part of the brain associated with reward anticipation and aggression -- was activated when investors made bad decisions based on trying to push the envelope, and another pathway -- the anterior insula, or AI, which responds to fearful stimuli -- was active when traders made mistakes trying desperately not to fail.

The researcher speculated that the activation itself, based on the investor's anticipated outcome from the trade, led to the behavior, rather than the other way around.

Collect Rewards Now or Later? To the Brain, It Matters
Functional MRIs were the order of the day for the team of Samuel M. McClure, David I. Laibson, George Loewenstein, and Jonathan D. Cohen (of various top-tier universities) as well. The researchers used MRIs to determine that different parts of the brain are responsible for making decisions about delayed rewards versus immediate gains: prefrontal cortex for the long term and limbic system for instant gratification. The practical implications from this research is not yet known.

More Testosterone Equals More Risk-Taking
In 2010, Paul J. Zak, professor of economics and founding director of the Center for Neuroeconomics Studies at Claremont Graduate University, published the results of experiments his team performed to manipulate brain chemistry artificially using one of three substances: oxytocin, arginine vasopressin, or testosterone.

The researchers created an empathy-generosity-punishment model based on the following axiom: "A person's physiologic state affects his or her decisions."

The doped-up participants were then invited, depending on their test group, to respond to specific prompts requiring them to either make a financial offer or decide to accept or reject an offer. Ultimately, Zak, et al., are hoping to come to some understanding of exactly what's in play physiologically when people take sweeping risks with trades.

(Bloomberg Television attempted to use one of Zak's charts to speculate on what might be happening in the minds of risk-taking outliers, like Jerome Kerviel, the former Societe Generale (SCGLY.PK) wonder boy who may have been the world's most famous rogue trader before the London Whale came along. See their interpretation, here.)

While the results of the drugging were to some extent inconclusive, naturally occurring testosterone does play a big part in risk-taking behavior -- surprise, surprise. Still, even researchers seemed taken aback by just how closely the level of the hormone correlates to the behavior.

In the mid-2000s, J. M. Coates and J. Herbert of the UK's University of Cambridge followed some British traders around the floor, poking and prodding them before delivering their somewhat shrinkage-inducing results:

We found that a trader's morning testosterone level predicts his day's profitability. We also found that a trader's cortisol rises with both the variance of his trading results and the volatility of the market. Our results suggest that higher testosterone may contribute to economic return, whereas cortisol is increased by risk. Our results point to a further possibility: testosterone and cortisol are known to have cognitive and behavioral effects, so if the acutely elevated steroids we observed were to persist or increase as volatility rises, they may shift risk preferences and even affect a trader's ability to engage in rational choice.

Based on these and other hormone-related findings, some have even suggested that reason might dictate leaving people with a genetic predisposition to low testosterone levels primarily in charge of risk analysis.

Then again, colleagues of JPMorgan's London Whale have described him as "a quiet bloke. Not an arrogant trader at all," and extremely humble. By all accounts, he in no way resembled the stereotypical testosterone-crazed risk taker one would imagine a rogue trader to be. And look how that turned out.

Twitter: @Church1Sara
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