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Salt Lake City — A new study published by the University of Utah’s David Eccles School of Business and the California Institute of Technology shows that in complex markets, financial bubbles are self-made when individuals intuitively track anomalies in market behavior as they would a strategic opponent. The research offers first-time proof that as people infer the intentions of others when making value judgments in complex financial markets, they may inadvertently cause the formation of financial bubbles.
“This study is so important and applicable because it provides empirical data that people intuitively use VPIN—something financial commentators have claimed for years without proof,” said Peter Bossaerts, a newly appointed professor of neuroeconomics at the University of Utah and a co-author on the study. “While these computational mechanisms in social situations are usually advantageous, when utilized in complex modern institutions like financial markets, they can result in maladaptive behaviors that drive bubbles and financial crashes.”
Bringing together experimental finance and the burgeoning field of neuroscience, study participants were placed in staged financial markets where bubbles could easily occur, and were then given the chance to buy or sell shares to their advantage. When participants noticed inconsistencies in market order flow, they subconsciously inferred there were insiders who held more market information and began tracking the anomalies using the same mechanical brain processes they would to track irregularities in strategic environments. As their brains activated strategic computational processes, they made poorly adapted business decisions, causing financial bubbles to form.
The study used functional MRI to map the brain’s computational processes throughout the experiment. Results suggest that during the formation of financial bubbles, participants’ choices were less driven by explicit information (like fundamentals and actual prices) and more driven by other computational processes—like imagining the trajectory of the market and the likely behavior of other traders. As participants imagined the market as a strategic opponent, the brain shifted into strategic computational mechanisms to make financial decisions, driving up product prices even though the value and demand had not actually changed—the random, inconsistent order flow only made it appear to have changed.
“We find that in a bubble situation, people start to see the market as a strategic opponent and shift the brain processes they’re using to make financial decisions,” said Dr. Benedetto De Martino, a senior researcher at Royal Holloway University of London who led the research team while at the California Institute of Technology. “They start trying to imagine how the other traders will behave and this leads them to modify their judgment of the asset’s value. They become less driven by explicit information, like actual prices, and more focused on how they imagine the market will change resulting in unproductive behaviors that drive a cycle of boom and bust.”
“It’s group illusion,” Bossaerts said. “When participants see the inconsistency in order flow, they think that there are people who know better in the marketplace and they make a game out of it. In reality, however, there is nothing to be gained because nobody knows better.”
“At the University of Utah, we are committed to driving pertinent and innovative research that can enhance our understanding of the business world,” said Taylor Randall, dean of the David Eccles Business School. “While much has been said of the psychology of economics, we rarely get to see strictly scientific information about what happens in the brain in financial situations. This study is particularly exciting because it gives us a broader understanding of what drives financial markets and how to avoid financial bubbles in the future.”