Bloomberg Markets

TK Month 2006

Brian Knutson says

stocks, like sex,
addle the brain.
 B l o o m b e r g M a r ke t s
March 2006

C O V E R S T O RY

By Adam Lev y
‚Late at night, in a basement laboratory at Stanford University, Brian Knutson
made a startling discovery: Our brains lust after money, just like they crave sex. Scientists
It was May 2004, and Knutson, a professor of neuroscience and psychology at
the California university, was sending student volunteers through a high-
power imaging machine called an fMRI. Deep inside each subject’s head,
plumb the
electrical currents danced through a bundle of neurons about the size and
shape of a peanut. Blood was rushing to the brain’s pleasure center as students mind to learn
executed mock stock and bond trades. On Knutson’s screen, this region of the
brain, the core of human desire, flashed canary yellow.
The pleasure of orgasm, the high from cocaine, the rush of buying Google
how fear and
Inc. at $450 a share—the same neural network governs all three, Knutson, 38,
concluded. What’s more, our primal pleasure circuits can, and often do, over-
greed drive
Wall Street.
ride our seat of reason, the brain’s frontal cortex, the professor says. In other
words, stocks, like sex, sometimes drive us crazy.

Mapping
the
Trader’s
Brain
PHOTOGRAPH BY MARKHAM JOHNSON
Bloomberg Markets
March 2006 C O V E R S T O RY : N E U R O F I N A N C E

Knutson says he knows how heretical his findings are. community, you’d better pay very serious attention to them.”
Wall Street is dedicated to the principle that when it comes to To proponents such as Kahneman, the potential of neurofi-
money, logic prevails, that intellect matters in investing. The nance seems virtually limitless. One day, brain science may help
idea is enshrined in the economic theory of rational expecta- money managers spot shifts in investor sentiment, says David
tions, for which Robert Lucas won the Nobel Memorial Prize Darst, chief investment strategist for the $700 billion individual
in Economic Sciences in 1995. Lucas, a professor of econom- investor group at New York–based Morgan Stanley.
ics at the University of Chicago, maintains that people make Armed with brain scans, psychotherapists may be able to
economic choices based on all the information available to hone traders’ natural impulses of fear and greed. Neurosci-
them and learn from their mistakes. As a result, their expec- entists may even develop psychoactive drugs, or neuroceu-
tations about the future—from the price of Citigroup Inc. ticals, that make people better, more-profitable traders,
stock next week to the earnings of General Motors Corp. next Knutson and other psychologists say. Look at Prozac. In the
quarter—are, on average, accurate. space of a few years, Prozac and other drugs have not only
revolutionized the treatment of depression but also pro-

O
r so the theory goes. In practice, of course, investors foundly changed the way we view the mind. People rec-
do foolish things all the time. Some gamble away for- ognize that chemistry drives their brains, moods and
tunes on money-losing investments, doubling down behavior—and that chemistry can change them. Similar
when logic tells them to fold, or letting winnings ride when drugs, ones that improve a trader’s decision making by 20–
the rational person would cash out. Others seem to have an 30 percent, may be just a few years away, says Zack Lynch,
uncanny knack for knowing when to buy and sell. In the managing director of NeuroInsights, a San Francisco–based
1970s, Richard Dennis parlayed an initial stake of several consulting firm that tracks the $100 billion neurotech-
thousand dollars into a $200 million fortune trading com- nology industry. If these neuroceuticals work, they could
modities in the Chicago futures pits. In the 1980s, hedge fund rock Wall Street. “The whole investment community will be
icon Paul Tudor Jones made $80 million by betting against scrambling to get these things,” Lynch says.
U.S. stocks just before the market crashed. In the 1990s, bil- So far, the hopes and claims of neurofinance have far out-
lionaire investor George Soros, the man who beat the Bank paced its science. Few investment professionals have even
of England, made $1 billion in an afternoon by shorting the heard of the field. Many who have dismiss it as hokum.
British pound. “It’s the latest malarkey,”
The question that keeps Attitude This mixture of traits makes for an effective trader. says Richard Michaud, pres-
nagging Knutson is this: ident of Boston-based New
Why do some traders get rich Frontier Advisors LLC,
while others walk away los- Unemotion which manages $100 mil-
ers? The answer, he says, lion in assets. Michaud, who
b
Flexi le
al

may lie somewhere in the has a doctorate in mathe-

96,000 kilometers (60,000 Humbl matics from Boston Univer-
Disciplined e
miles) of neural wiring in- sity, says neurofinance and
side our brains. The results e Self-awar its forerunner, behavioral
iv e
of the Stanford study, pub- cis finance, have no place on
De

lished in the September issue Wall Street. “I find these so-

of Neuron magazine, have called disciplines to be more
caused a stir among the of a marketing tool, a way of
small group of neuroscien- taking an ages-old market
tists and psychologists who valuation problem and call-
are mapping the human ing it something space-age,”
brain in hopes of under- Michaud says. “I doubt it
standing investor behavior. will be fruitful.”
This controversial field, Knutson’s response: Just
called neurofinance, may Source: marketpsych.com wait. “Investors want to beat
represent the next great the market and become bet-
frontier on Wall Street, says Daniel Kahneman, who won the ter traders,” he says. “The first step is to know how the ma-
2002 Nobel Prize in economics for his pioneering
FILE neurpro4 work in be- chinery works. The applications to exploit the machinery will
havioral finance, which fuses classical
SIZE economic
13p0 x 20p0 theory and soon follow.”
studies of human psychology. NOTES New size People have been trying to explain how financial markets
“The brain scientists are the wave of the future in the finan- work for more than a century. In 1900, French mathemati-
DECORATIVE
cial world,” Kahneman, 71, says. “If you seek to maximize un- cian Louis Bachelier argued that markets were essentially
derstanding, whether you’re in academia or in the investment random. John Maynard Keynes, in his famous 1936 work,
 B l o o m b e r g M a r ke t s
March 2006

Circuits: The brain’s pleasure center, left, fires when people make risky trades. Other neurons, right, take over when people try to avoid losses.

General Theory of Employment, Interest and Money, lik- Popular Delusions and the Madness of Crowds, written by
ened the stock market to beauty contests that ran in news- Charles Mackay in 1841, remains a Wall Street classic to this
papers of his day, in which readers were asked to pick the day. Mackay examined the history of alchemy, witch hunts,
prettiest face. The key to selecting the winner, Keynes ar- fortunetelling and speculative frenzies such as the mania
gued, isn’t choosing the face you think is the most beautiful over tulips that gripped Holland in the early 17th century,
but rather anticipating the face other people will pick. when the flower bulbs traded at a higher price than gold. His
American securities analyst John Burr Williams argued in book shows how otherwise intelligent people sometimes suc-
1938 that the price of financial assets reflects a measurable cumb to mass idiocy. Terms used in psychology have become
intrinsic value, a notion that fits with the value investing ap- ingrained in the language of investing. A rush for junk bonds
proach advocated by Benjamin Graham. The so-called effi- or Internet stocks is a “mania”; an economic collapse is a “de-
cient market hypothesis, popularized by economist Eugene pression.” Keynes coined a colorful term for one of the vital
Fama in the 1970s, holds, as Bachelier did, that price chang- ingredients of economic prosperity, the naive optimism that
es are random. In other words, no one can forecast markets prompts people to cast aside their fears despite all experi-
accurately. According to Fama and his followers, technical ence: “animal spirits.” In the 1970s, Kahneman began exploring
traders, who believe they can predict
prices by examining patterns of price
movements, are wasting their time.
Chartists can’t beat the market. No
‘Brain scientists are the
one can, at least not for long.
For Wall Street, brain science even-
wave of the future in the
tually could mean big money, Morgan financial world,’ says Nobel
Stanley’s Darst says. Securities firms
spend millions of dollars annually re-
laureate Daniel Kahneman.
searching companies and crunching
numbers in an attempt to predict the
financial future. “Meanwhile, we spend peanuts on human how investors systematically make judgment errors or mental
psychology,” says Darst, author of The Complete Bond Book: A mistakes. They follow the herd, trade excessively and react too
Guide to All Types of Fixed-Income Securities (Random slowly to unexpected news, he concluded.
House, 1975). “We have to take account of the deep atavistic Soros, 75, has a theory about why markets behave the way
and visceral traits and instincts that are triggering the buying they do. He calls it reflexivity. The gist of it is that markets
and selling of securities.” can’t discount future events correctly because they actually
The idea that something other than reason sometimes help shape them. Consider the Nasdaq Stock Market boom
drives economic decisions is hardly new. Extraordinary and bust of the late ’90s. Young, money-losing companies
Bloomberg Markets
March 2006 C O V E R S T O RY : N E U R O F I N A N C E

depended on their ability to finance themselves in the capital neocortex—center of our higher mental functions—is capa-
markets. When stocks are climbing, such companies can raise ble of making 100 trillion connections. Scientists don’t
money easily. A rising stock makes a startup more viable, know how these billions of neurons give rise to conscious-
which leads to an even higher stock price, which makes the ness and coordinated behavior. They don’t understand the
company more viable still, and so on and so on. The same brain’s electrochemistry. They’ve yet to determine how
thing happens in reverse when stocks decline. genes and experience, nature and nurture, shape the brain.
Soros’s son, Robert, has offered his own explanation of One August afternoon, as the brilliant California sun beats
his father’s trading success. In Soros: The Life and Times of down on Stanford’s sprawling, mission-style campus, Knut-
son sits inside his darkened second-
floor office with the shades drawn.

The human neocortex—center He’s studying something on his com-

puter. The image on his screen looks
of our higher mental func- like a Rorschach ink blot, or maybe a
halved cauliflower. It’s a scan of a
tions—is capable of making human brain—one of Knutson’s trad-

100 trillion connections. er test subject’s—lit up in blue, yellow

and pink.
Knutson has sandy hair cut school-
boy short, a crooked grin and wire-rim
a Messianic Billionaire (Knopf, 2002), a biography of the glasses. His baggy white oxford shirt is rumpled, and his
money manager written by former New York Times colum- shirttails trail outside his trousers. He rarely sits still and
nist Michael Kaufman, Robert Soros, 42, says of his father: tends to rock and fidget while pattering about neurochemis-
“You know the reason he changes his position on the market try and brain connectivity. His appearance and mannerisms
or whatever is because his back starts hurting him. He liter- bring to mind a young, overcaffeinated Bill Gates. Papers are
ally goes into a spasm, and it’s this early warning.” scattered on his office floor. An empty Peet’s coffee cup sits
What makes a great trader? Alan Greenberg, chairman atop his desk.
of the executive committee of Bear Stearns Cos., says the “This is so cool,” Knutson says, pointing to the yellow
successful ones understand risk, absorb information and area in the center of the scan. It’s the nucleus accumbens—
make quick, calculated decisions. They have the self-confi- the pleasure center—of one of his volunteers.
dence to take a loss and move on, he says. Some of these

K
qualities come down to instinct, says Greenberg, who joined nutson has been trying to map the money mind since
New York–based Bear Stearns in 1949 and still sits on a 1996. After graduating in 1987 from Trinity Universi-
trading desk. Even so, Greenberg doesn’t buy neuroscien- ty in San Antonio, Texas, where he double majored in
tists’ claims that such instincts are rooted in our brain. experimental psychology and comparative religion, Knutson
“There’s smarts, there’s guts and there’s instincts,” Green- earned a Ph.D. in experimental psychology from Stanford.
berg, 78, says. “The other stuff—behavioral, neuro, whatev- He got involved in brain imaging while doing a postdoctor-
er they call it—is horseshit.” al fellowship at the University of California, San Francisco.
Kenneth Griffin, founder of Chicago-based Citadel Invest- “I figured if I can’t delve into the brain, I’ll never really know
ment Group LLC, says some people are natural traders. “Great how it works,” he says.
investors understand risk and reward at an intuitive level,” It was at the University of California that Knutson first
Griffin, 37, says. began to discover how money plays on the brain. “We very
Andrew Lo, a professor of finance and investment at the quickly found out that nothing had an effect on people like
MIT Sloan School of Management, says conventional finan- money—not naked bodies, not corpses,” he says. “It got peo-
cial analysis fails to take into account human behavior. “Fi- ple riled up. Like food provides motivation for dogs, money
nance and economic research has hit a wall,” says Lo, 45, provides it for people.” He eventually landed a grant to con-
who runs AlphaSimplex Group LLC, a Cambridge, Massa- duct brain scans specifically related to investing.
chusetts–based hedge fund firm with $200 million in as- Later that August afternoon, Knutson hustles across cam-
sets. “We can’t answer any more questions by running pus to the Richard M. Lucas Center for Magnetic Resonance
another regression analysis. Now, we need to get inside the Spectroscopy and Imaging, home to Stanford’s two functional
brain to understand why people make decisions.” magnetic resonance imaging machines, or fMRIs. Each of
To most neuroscientists, the mind and the brain are one these $2.5 million contraptions is the size of a small truck and
and the same. They see the brain as the physical basis for weighs 12 tons. Unlike X-rays, MRI scans don’t use radiation
all our thoughts, beliefs and emotions. Yet researchers to peer inside the body. Instead, they use powerful magnetic
scarcely understand what goes on inside our heads. With fields to make the body’s cells vibrate, generating electrical sig-
100 billion cells, each with 1,000 to 10,000 synapses, the nals that are then interpreted by a computer and turned into
 B l o o m b e r g M a r ke t s
Month 2006 TK

detailed images of slices of the body. Such devices are used on

patients with conditions ranging from brain tumors to knee
injuries. Unlike traditional MRIs, fMRIs can create moving
Wiring
images, not just static ones. They can capture the flow of blood
through the brain, painting a picture of our mental activity in
a palette ranging from hot pink to chromium yellow.
Traders
Before entering an fMRI, you must remove or put away The S&P 500 is down 4 at 1293—sell! Ten-year Treasuries are
anything that might contain metal: belts, shoes, cell phones, up 1/4 to yield 4.45—buy! Your pulse pounds. Your palms sweat.
keys, coins and so on. While fMRIs and MRIs are generally And according to a 2004–05 study conducted at Stanford
considered safe—millions of imaging tests are conducted an- University, certain parts of your brain go into overdrive.
nually in the U.S. alone—accidents sometimes happen. The Stanford professor Brian Knutson and Camelia Kuhnen, a
machines’ electromagnets are so powerful that they’ve sent graduate student at the university’s business school, designed an
metal objects, including oxygen experiment to determine how
tanks and cleaning equipment, traders make decisions. They
rocketing through the air. used a neural scanner to chart
Cleared of all metal, you lie the brains of 19 healthy volun-
face up on a table that moves in teers as those people executed
and out of a magnetic cylinder. mock stock and bond trades. The
Once inside, only a few inches test subjects included doctoral
of space remain between you candidates in finance and eco-
and the surface of the cylinder. nomics, as well as grad students
The confines can be so claustro- in the humanities.
phobic that a few of Knutson’s First, Knutson and Kuhnen
subjects bailed out of his study. created a computer game they
During their hour-long scans, called the Behavioral Investment
Knutson’s 19 volunteers—10 Allocation Strategy task, or
women and nine men—had to BIAS, to elicit a range of invest-
bite down on a piece of plastic ment behaviors from their volun-
to keep their heads still. They teers. The game consisted of 20
also had to wear plastic ear- blocks of 10 trials each. During
phones, to drown out the whir each trial, subjects first saw two
of the fMRI, and wear video- stocks and a bond, waited a few
display goggles so they could ex- seconds and then chose one of
ecutive their mock trades. the investments when the word
Here’s how the experiment choose appeared on their video
worked: The subjects, who display. After each try, their
ranged in age from 24 to 39, earnings for that round and their
were given $20. In each round total earnings were displayed.
of the test, the volunteers got to choose among three invest- Wired: MIT’s Lo found Before the subjects entered
ments. The first was a bond that was guaranteed to return $1 that traders’ pulses and the scanner, they played a prac-
breathing quicken when
per round. The second was a safe stock, with a 50 percent they take risks. tice version of the game for at
chance of earning $10 per round and a 25 percent chance of least 10 minutes. They were then
losing $10. The third was a risky stock, with a 50 percent shown the cash they could win by playing the game successfully.
chance of losing $10 and a 25 percent chance of winning $10. They were paid $20 an hour and got to keep 10 percent of their
Knutson didn’t tell his volunteers which stock was which, so winnings. “We needed to have the subjects involved, and there’s
his subjects had to rely on the stocks’ history. no motivator like money,” Knutson says.
The study found that the students made irrational choices

T
hree out of four times, the volunteers made wise, ratio- 25 percent of the time. It didn’t matter whether they were
nal choices. Every fourth try, however, they exercised students of finance or philosophy. The scans showed that the
bad judgment, usually by chasing profit by selecting brain’s nucleus accumbens, the pleasure center linked to sex and
one of the two stocks when the bond would have been the drug addiction, is activated when we take trading risks. Another
smart choice or opting for the safety of the bond when they part of the brain, the anterior insula, lights up in brain scans
ASIA KEPKA

should have taken a gamble on one of the stocks. In each case, when we try to avoid losses. Some of the students went home
the fMRI captured what was going on inside their brains as with $40—a 100 percent return. Others lost all but $5.
they made their trades. ADAM LEVY
Bloomberg Markets
March 2006 C O V E R S T O RY : N E U R O F I N A N C E

While dopamine flows during our moments of pleasure,

these two chemicals course through the brain when
we’re fearful or anxious. The sight of something disgust-
ing or disturbing, such as a mutilated body, automatical-
ly triggers the release of these chemicals, Knutson says.
When we make trading decisions, our brain’s cen-
ters for pleasure and angst wage battle. The first seeks
profit; the second tries to avoid loss. Subjects who
showed high activity in the anterior insula were 20
percent less likely to invest in a stock that had lost
money before, even when the odds were good that
they would profit. Such people might sell impulsively
when markets turn against them, Knutson says.
Richard Peterson, a San Francisco–based psychia-
trist, says Knutson’s work might eventually lead to
therapies and drugs that help override error-causing
emotions. “This study pinpoints the neural targets we
need to go after,” Peterson, 33, says.
Wall Street is just one part of the business world
that might profit from such brain science. It doesn’t
take a neuroscientist to know that salespeople and
marketers try to mess with our heads all the time. They
Morgan Stanley’s David Darst wants to know what drives investors. may not know it, but insurance agents who show pros-
pects photos of fire-gutted homes are activating their
Before the students made a risky bet, investing in a stock marks’ anterior insulae. Casinos that surround gamblers with
that had burned them before, their nucleus accumbens food, drinks and prizes are appealing to the dopamine circuits
flashed yellow on Knutson’s screen. This part of the brain is of the pleasure center.
driven primarily by dopamine, a chemical that scientists be-

G
lieve produces pleasure and euphoria. Dopamine fuels our emma Calvert, who has a doctorate in brain imaging
reward response, and brains can’t get enough of the stuff. from Oxford University, is attempting to tap into con-
When scientists insert an electrode into the nucleus accum- sumers’ brains. Her Oxford-based firm, Neurosense
bens of a rat, the rodent will press a lever that delivers a jolt Ltd., has tried to help Omnicom Group Inc., a New York–
to this region of its brain until the animal collapses from ex- based advertising company, figure out whether print, radio
haustion or dies. Doctors who have performed similar exper- or television ads make the biggest impact on the brain. Vol-
iments on humans during unteers watched TV, listened
brain surgery have reported High alert The body automatically responds when a person to radio and read magazine
that some of their patients makes a risky trade. advertisements while Cal-
experience orgasms. All vert studied their brains’ re-
drugs of abuse, from co- actions. The results, she says,
caine to heroin, activate our were inconclusive. “We’re not
Breath rate Pupils
dopamine circuits. increases dilate pretending we can find a con-
Before the volunteers sumer’s ‘buy button,’” Calvert
made a safe investment, a dif- says. All the same, brain sci-
ferent part of the brain, the ence is still in its infancy, and
anterior insula, was activat- its potential in advertising
ed. While our nucleus ac- and marketing could be enor-
cumbens may goad us on, our Perspiration mous, she says.
Heartbeat
anterior insula is believed to level Not everyone says scien-
quickens
elevates
hold us back with anxiety tists should spend time and
that can at times be irratio- money plumbing the brains of
nal. The anterior insula is Blood
traders and consumers. Neu-
KENNIS KLEIMAN

primarily driven by two other pressure rofinance research ties up ex-

rises
neurotransmitters, serotonin pensive medical equipment
and norepinephrine, also that should be used to heal
known as noradrenaline. people, says Gary Ruskin,
Source: Bloomberg

FILE neurdec4
Bloomberg Markets
March 2006 C O V E R S T O RY : N E U R O F I N A N C E

before making a big trade. If nothing

‘There’s smarts, there’s guts else, the findings of brain researchers
have made him more aware of his emo-
and there’s instinct,’ Bear tions and motivations, he says.

Stearns’s Greenberg says. He For now, neurofinance is more sci-

ence fiction than science fact. While
says neurofinance is a sham. brain scans have begun to back up the
Nobel-winning theories of behavioral
finance, scientists have a long way to
go before their research translates into
executive director of Commercial Alert, a Portland, Oregon– profit on Wall Street, says Peterson, the San Francisco psy-
based nonprofit organization that fights what its members chiatrist. “So far, neurofinance is ‘all hat and no cattle,’ as my
see as the creeping commercialization of American culture. Texan relatives might say,” Peterson says.
His group has called for a ban on using fMRIs for anything Back at Stanford, Knutson says he’s confident his research
but fighting disease. “There’s an opportunity cost of using will pay off one day. Unlocking the mysteries of the human
these machines,” Ruskin, 40, says. “I’d rather we use them to brain is the greatest challenge that scientists have ever faced,
spot a tumor and save a life than earn an extra fraction of a he says. “Brain imaging gives us the hope of opening up the
percentage from stock trades.” black box,” Knutson says, and money may be the key.
Lo, at MIT, is unbowed. He says neuroscientists might be
able to help traders conquer emotions that cloud judgment. Lo ADAM LEVY is chief of the Atlanta bureau of Bloomberg News.
has studied traders at work and learned what people such as adamlevy@bloomberg.net

Bear Stearns’s Greenberg have known for decades: Gut mat-

ters. In 2002, Lo wired 10 currency traders at a Boston broker- For a g raph of a stock’s average pr ice, type its
age to equipment that measured their heart rates, breathing, t icker followed by <Eq u ity> G PA <Go>.
body temperatures, blood pressure and perspiration.
During the course of a single day, the traders together
made 1,200 split-second trades averaging $4 million.
Their pulses pounded, their breathing became heavy,
their palms sweated. Lo concluded that greed and fear
played a big role in the traders’ decisions and that in-
experienced traders were the most likely to make emo-
tional mistakes. A similar study conducted by Lo in
2005 found that the most-successful traders were
those who managed to keep their emotions on an even
keel whether they were making money or losing
money. “Emotions definitely count,” Lo says. “Now, I
want to dig deeper into the brain to better understand
what is going on and see if we can refine our applica-
tions in the real world.”

K
nutson’s Stanford study caused a buzz in Sep-
tember at the third annual conference of
the Society for Neuroeconomics, held at the
Kiawah Island Golf Resort in South Carolina. The
three-day event drew 115 people, mostly from aca-
demia. The sole Wall Streeter was Arnold Wood, who
helps manage $4 billion at Martingale Asset Man-
agement in Boston. He says he’s confident neurofi-
nance will catch on among other investors.
“People scoffed at behavioral finance, calling it BS,”
Wood says. “But its underlying premise was right: In-
vestors make mistakes, and the more we can under-
JOHN CLARK

stand about why and how, the sooner we can correct

them.” To Wood, neurofinance research reinforces a
Activist Gary Ruskin says scientists should help the sick, not Wall Street.
common-sense lesson: One should stop and think