Neuroeconomics really explains human economic behavior

Often a new field comes along purporting to offer bold new insights into questions that have long vexed us. And often, after the initial excitement dies down, that field turns out to really only offer a bunch of new names for stuff we basically already knew. I used to think neuroeconomics was such a field. But I was wrong.

Neuroeconomics mixes brain science with the dismal science — throwing in some evolutionary psychology and elements of prospect theory as developed by Daniel Kahneman and Amos Tversky — to explain the emotional and psychological quirks of human economic behavior. To take a common example — playing the stock market. Our brains are always prospecting for pattern. Researchers at Duke University showed people randomly generated sequences of circles and squares. Whenever two consecutive circles or squares appeared, the subjects' nucleus accumbens — the part of the brain that's active whenever a stimulus repeats itself — went into overdrive, suggesting the participants expected a third circle or square to continue the sequence.

The stock market is filled with patterns. But the vast majority of those patterns are meaningless, at least in the short term. The hourly variance of a stock price, for example, is far less significant than its annual variance. When you're checking your portfolio every hour, the noise in those statistics drowns out any real information. But our brains evolved to detect patterns of immediate significance, and the nucleus accumbens sends a jolt of pleasure into the investor who thinks he's spotted a winner. Yet studies consistently show that people who follow their investments closely earn lower returns than those who don't pay much attention at all. Why? Because their nucleus accumbens isn't prompting them to make impulsive decisions based on momentary patterns they think they've detected.

The beauty of neuroeconomics is that it's easily verified by personal experience. A while back, I had stock options that I had to exercise within a specific period of time. So I started paying attention to the markets on a daily basis, something I normally never do. I was mildly encouraged every time the stock price ratcheted up a notch or two, smugly satisfied that I hadn't yet cashed in my options. But I was devastated when the price dropped back down again, recriminating myself for missing a golden opportunity. (This was Kahneman and Tversky's "loss aversion" — the tendency to strongly prefer to avoid a loss rather than to acquire a gain — kicking in. Some studies suggest that the fear of a loss has twice the psychological impact as the lure of a gain.) I eventually exercised my options after the price hit a level it hadn't reached for several years. I was pretty pleased with myself — until the firm sold some of its businesses a few weeks later and the stock price shot up by several dollars.

Neuroeconomics really does explain the non-rational aspects of human economic behavior; it is not just another way of saying there's a sucker born every minute. And now, thanks to this new field, I can blame my bad investment decisions on my nucleus accumbens rather than my own stupidity.