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Inside the brain of a trader: A biomarker for irrational exuberance

Inside a trader's brain
Inside a trader's brain

"A simple rule dictates my buying," the investor Warren Buffett wrote in a 2008 New York Times op-ed. "Be fearful when others are greedy, and be greedy when others are fearful."

Turns out, Buffett's got neuroscience backing him up.

Certain areas of the brain associated with reward and response to gut feelings have shown links to trading behavior and success, according to research published Monday in the journal Proceedings of the National Academy of Sciences. The study shows that activity in one area of the brain actually tracks price bubbles—and that higher earners get signals from a different area that are associated with selling before a price bubble peaks.

The work, done by researchers at the California Institute of Technology and Virginia Tech, sheds light on what goes on in the brains of traders in periods of irrational exuberance—that time of extreme market enthusiasm that can precede a bubble. It also showed more successful traders got brain signals that told them to listen to their gut and sell before a bubble burst.

Traders on the floor of the New York Stock Exchange.
Lucas Jackson | Reuters

With the research, "we might make more realistic models of the market," Read Montague, a professor at Virginia Tech and University College London and an author of the paper, said in a telephone interview Monday. The findings could provide "behavioral suggestions based on neural data that might mitigate" pricing bubbles, he said.

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The study was conducted in 16 experimental trading sessions with 320 participantsmostly students at the University of California, Los Angeles. They went through 50 trading rounds, and two to three volunteers per session did the experiment while undergoing magnetic resonance imaginglying on their backs in an MRI machine.

The findings are twofold. The first focuses on an area of the brain called the nucleus accumbens, an evolutionarily ancient area associated with reward. The researchers found that as prices rose, so did activity in that part of the brain, establishing what they call a biomarker for irrational exuberance.

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"If you put somebody in a market situation and the price runs much higher than it really should, there's a region of your brain that's evolutionarily old that tracks that like it's a reward, like it would squirts of juice in your mouth," Montague said. "Your brain is being very exuberant and tracking a price bubble."

The second finding is in a relatively newer area of the brain called the anterior insular cortex, which is "active during bodily discomfort and unpleasant emotional states, such as pain, anxiety and disgust," the researchers wrote in the paper.

It's associated with responding to gut feelings or signals from the body, said Alec Smith, a researcher at Caltech and the lead author of the paper.

Study participants who were more successful traders turned out to have higher activity in that area and more frequently sold before market peaks.

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"It may be that high-earning traders are saying, 'Oh wow, I'm getting very excited, my heart's beating faster, maybe I should step back and figure out if what we're all doing here makes sense,'" Smith said by telephone. "They're selling before the peak."

The research builds on earlier findings about these areas of the brain, said Brian Knutson, a neuroscientist at Stanford University who was not involved in Monday's study.

"This research shows that neural signals not only correspond to but predict important financial events in an experimental market," Knutson wrote in an email. "If this experimental market operates according to the same principles as larger markets, the findings open up the possibility of a 'minority report' approach to predicting market events."

He noted that only some traders have the anterior insula activity that predicts a market crash. "Who are these individuals and do they do better in real life? (e.g. Warren Buffett). The findings provide neural evidence that emotion can move (experimental) markets."

Still left to study is whether different people do better in different markets, Knutson said. "For instance, bullish traders may do poorly in a rising market, but better in a falling market, and vice versa."

It also isn't clear whether the signals these more successful traders get are conscious, Montague said, but the effect is strong.

"It really is uncanny how tuned that group is," Montague said. They feel the same exuberance as other participants in the pricing bubble, he said, but they respond to signals that allow them to get out before it bursts. "It begs the question: Are these people made or are they born?"

The answer to that is beyond the scope of this research, he said. And, Smith notes, "I don't think we think the Fed is going to run out and buy a bunch of fMRI machines" to use brain signals to better regulate the market.

But the research does provide a glimpse into the biological differences between tradersand supports the investment thesis of one of the world's richest people, Warren Buffett.

"Our experimental results support the first part of his advice to a surprising degree," the researchers wrote. "Wiser traders who begin selling when their insula is active (indicating discomfort) sell a few periods before the peak to traders with the highest 'greed,' measured by increased nucleus accumbens-buying sensitivity."

—By CNBC's Meg Tirrell