In many aspects of life, knowing what influences people’s decision-making can help solve some of the world’s most complex problems. Research in the financial sector has been dumbfounded by this very question since the advent of the stock market. Classical financial theory assumes investors behave with rational expectations in order to maintain an efficient market. Yet as we know, the idiosyncrasies in human behavior vary and financial markets tend to fluctuate up and down as a result. Recently, economists have begun to adopt the insights of behavioral science as a more realistic interpretation of financial markets. Behavioral economics incorporate aspects of cognitive psychology with conventional finance to provide an explanation for irrational and rational decision making. The insights from behavioral economics has made strides in proving that human behavior does not act consistently with economic theory, but has also paved the way for the budding field of neuroeconomics. Neuroeconomics attempts to bridge neuroscience, cognitive psychology and economics in order to understand the mechanisms underlying economic decision making.
What is Neuroeconomics?
The human brain has often been referred to as the most complex biological structure and something akin to a black box. The foundations of economic theory were constructed assuming that the details of the human brain would not be discovered. However with advances in technology, neuroscience has produced techniques to infer details and imaging of brain activity. By studying human neural networks, motivate and pleasure systems in the human brain can provide insight into why humans do not always act in ways that optimize utility. Popular research suggests that neuroscience can be broken down into four specific economics topics; intertemporal choice, decision making under risk and uncertainty, and game theory.
In economics, the standard perspective views intertemporal choice as a tradeoff of utility over different points in time. For individuals and financial institutions, these decisions can relate whether they choose to make a decision today or in the future. In a traditional discounted utility model, humans will discount all future utilities at a constant rate. Yet, the notion of time discounting does not describe the behavior of individuals because the human brain is able to take long-term consequences into account. Based on the actions of the prefrontal cortex, values between small delay periods will fall more rapidly than longer delay periods. That is, outcomes are weighted less the more remotely in time they occur; the subjective value of a reward is smaller when it is delayed than when the same reward is available immediately. Often times strong intertemporal choices are made when deciding how much to save for retirement, whether to buy a house or how to invest. In the capital markets, consumers should make intertemporal tradeoffs so that their marginal rate of time preference equals the interest rate.
Decision Making Under Risk and Uncertainty
Fundamental to economics and social sciences is the observation of human decision-making under conditions of risk. A utility model views decision making under uncertainty as a tradeoff of utility under different states of nature, similar to delayed outcomes. Humans will often react to risk on multiple levels; they will objectively evaluate risk and react in a rational manner or they will have an emotional reaction. This is commonly found in phobias in which many people are unable to face a risk that they objectively recognize as harmless. When it comes to investing, humans are averse to losing more so than pursuing gains. Neuroeconomic research suggests that physiological responses to negative losses are more severe than equivalent gains.
In social interactions, knowing how each person acts and how they think you act is critical in predicting the behavior of other people. Neuroeconomists have studied these situations in terms of altruism, cooperation, punishment and retribution. The most frequently referenced interaction in economics is the prisoner’s dilemma in which each prisoner’s payoff is contingent on both their own choice and the other player’s. Consistent with the prisoner’s dilemma, equilibrium is found when both players mutually cooperate and leave a higher payoff on the board. When players cooperate and trust each other, the presence of oxytocin rises, which is the hormone that influences social bonding. However, when an unfair offer is proposed, the brain struggles to resolve the conflict between accepting an offer and rejecting it as a result of disgust or unfair treatment. In today’s financial landscape, trust and experience are preventing many investors from reconciling the difference between risk and reward.
Challenge to Conventional Wisdom
Fundamental to a new theory is its ability to address the shortcomings of conventional wisdom. In this case, efficient markets and modern portfolio theory has predominated neoclassical economic theory. Simply, it assumes investors act rationally in order to systematically maximize their own utility. The rise in behavioral and neuroeconomics has proven that rationality is problematic and a more accurate assessment of decision making incorporates emotional biases. A common pitfall to prevailing economic theory is its inability to explain behavior and decisions make during times of crisis which is typically driven by irrational behavior. That being said, emotional responses are not always suboptimal in nature, but they are not as aligned with standard economic theory.
The Bottom Line
With the rise of technology, growing fields such as neuroeconomics have challenged conventional economic theory to more accurately describe economic decisions making. Fundamentally neuroeconomics identifies how humans process essential elements of utility theory when faced with risk and uncertainty. Our emotions have more profound effects on our decision making rather than what we know to be true. As we gain a better understanding of the mechanisms of the brain, we will continue to learn how the economies work or fail to work.