“BEHAVIOURAL FINANCE

ASSIGNMENT”

Submitted To –

Prof. Valeed Ahmad Ansari

SUBMITTED BY -

KHYATI

ROLL NO. 18MBAA10

DEPARTMENT OF BUSINESS ADMINISTRATION

FACULTY OF MANAGEMENT STUDIES AND RESEARCH

ALIGARH MUSLIM UNIVERSITY

ALIGARH
Ques1. As compared to classic studies in behavioral finance, how does
neurofinance achieve additional explanatory power over non-optimal
financial decision-making?

Ans. Behavioral finance is a relatively new school of thought that deals with the influence of
psychology on the behavior of financial practitioners and its subsequent impact on stock
markets. It signifies the role of psychological biases and their specific behavioral outcome in
decision making. Meir Statman explains its concept in a more straight forward term by
stating that “People in standard finance are rational. People in behavioral finance are
normal”. Behavioural finance studies describe market price anomalies and individual
decision biases. Unfortunately, such descriptions of behaviour have not proven amenable to
generalization or predictive modelling.

Neurofinance research help us to understand how individual biases, irrational behaviour, and
collective buying and selling decisions emerge by using research tools and techniques
borrowed from the field of neuroscience. The use of neuroscientific research tools allows
economists to look at biological drivers of decision-making. In particular, many economists
are interested in investigating the origins of the non-optimal decision-making.

Experimental apparatuses in such research mainly include neuroimaging techniques such as

functional MRI, Positron emission tomography (PET). Other less widely used imaging
techniques include magnetic resonance spectroscopy (MRS) and optical tomography (a brain
activity monitoring technique using infrared light).

Electrophysiology, sympathetic nervous system (SNS), Electromyograghs (EMGs),

electroencephalograms (EEGs), behavioural monitoring equipment, hormone assays, genetic
tests, report surveys, behavioral observation, personality testing, and specific psychometric
instruments including affect, depression, anxiety, psychoticism, impulsivity, and intuition
rating scales are some of the other techniques to be used in neurofinancing studies.

Issues addressed by neurofinance research include:

(1) Financial risk taking (both excessive and aversive);

(2) Expectation formation;

(3) Valuation;

(4) Information presentation and updating such as framing, reference points, and affective
loading;

(5) Probability assessments under conditions of risk, uncertainty, and ambiguity; and

(6) Cooperation, competition, herding, and social influences on choice.

Neurofinance field describes the progress researchers have made in contributing to our
understanding of financial risk taking (including concepts of utility, emotional priming,
probability assessments, and reference points) and social influences on choice (including
moral concepts such as reciprocity, cooperation, trust, and revenge) by correlating the field of
finance with neuroscience helping us to understand the human brain which is responsible for
motivation, emotion, self-reflection, and strategy.

Therefore, neurofinance certainly achieve additional explanatory power over non-optimal

financial decision-making as compared to classic studies in behavioral finance.
 Ques2. Biologically speaking, what are some brain structures and
chemicals that influence financial decision-making?

Ans. The brain can be conceptualized as having three major anatomical divisions- outer layer,
middle layer and innermost core. This conceptual schema is termed the “Triune” brain:

- The cortex is the brain’s logistical center. It is the director of executive function and
motor control. The part of the cortex called the prefrontal cortex is involved in
abstract thinking, planning, calculation, learning, and strategic decision-making.
- The brain’s limbic system is the emotional driver of the brain. The limbic system is
the source of primitive motivations and emotions including fear and excitement.
- The third division of the brain is called the midbrain (also known as “the reptilian
brain”). The midbrain manages the body’s basic physiological processes, including
respiration and heart rate.

Two major brain functions which are fundamental to almost all human behaviour:

Reward approach (pleasure seeking) Loss avoidance systems (pain

avoidance)
 Dopamine was historically called the
“pleasure” chemical of the brain.
 Activated when the brain recognizes
potential threats or dangers such as
 On one hand, hypoactivation or anxiety, fear and panic in one’s
desensitization of the reward system environment. Pessimistic and worried
results in a propensity to feel apathetic, thoughts are the cognitive sequelae.
have low energy, and engage in
compensatory excitement and novelty-
 It runs through several regions of the
seeking behaviors such as pathological
brain’s limbic system.
gambling and compulsive shopping.
 Its activity is mediated by serotonin and
 On the other hand, short-term gains
norepinephrine (among other
energize dopamine flow in the reward
neurotransmitters) and can be
circuit.
modulated with antidepressant
medication such as selective serotonin
reuptake inhibitors (SSRIs).
Biological factors can also influence financial decision-making. Dietary changes, medications
and illicit drugs, exercise, and other techniques shown to alter the brain’s neurochemical
activity could alter decision- making. Neurofinance researchers such as Mohr, Li, and
Heekeren also find alterations in risk taking over the life span, with age-related changes in
financial risk taking.

Medication in the beta blocker family decreased experimental subjects’ ability to perceive
potential financial losses during a risky task. While talking about the medications,
Benzodiazepine administration is associated with a dose-dependent increase in financial risk
taking.

Manipulations of diet (including dietary restrictions such as branched amino acids to lower
endogenous tryptophan levels) and administration of exogenous chemicals such as
medications, foods, vitamins, hormones, and intoxicants (benzodiazepines, amphetamines,
cocaine, tetrahydrocannabinol (THC), and alcohol) significantly affect financial decision-
making.
Ques3. What techniques, supported by neurofinance, do successful
financial practitioners use to improve their performance?

Ans. Currently no evidence-based decision tool based on neurofinance research is available

to improve individual investment decision-making. Numerous technical limitations constrain
the real-world application of tools such as fMRI and facial EMG for trader decision-making,
although many successful financial practitioners, such as Ray Dalio, Bill Gross, Steve Cohen,
Paul Tudor Jones, George Soros, etc. use various techniques supported by neurofinance to
improve their performance.

They use strategies such as meditation, establishing a rule driven process, using a coach, and
altering information display to reduce emotional (affective) arousal and resulting
misjudgements. Research shows that cognitive strategies including reappraisal, reframing,
and decision journaling can reduce financial decision biases.
These strategies can be stratifies into two categories:
- Behavioural Strategies
- Cognitive Strategies

1) Behavioural Strategies
a. Meditation - A process of cultivating self-awareness of thoughts and feelings.
Relieves stress and anxiety. Insights into the relations between thoughts and feelings
facilitate interruption of negative patterns. Styles include transcendental, mindfulness,
and moving meditation such as yoga.
b. Rule-driven Process - Establishing a rule-driven process for decision making dempens
the impact of mild affective arousal. Such a process minimizes affect aggravated
biases in the decision process.
c. Coaching - Coaches reinforce both affective and cognitive strengths, enhance mental
flexibility in the midst of rule-following, and bolster discipline and selfawareness.
d. Information Display - Eliminate purchase price and price change from information
display to reduce affective reactions.
2) Cognitive Strategies
a. Reappraisal - Losses are reframed in larger context as :
- Expected: “you win some you lose some”
- Low impact: “part of a portfolio”
- Routine: “risk is reality in my job”
- Minor: “doesn’t change my life”
- Serial: “every day there are some”
b. Reframing - Losses are seen as a positive opportunity for learning. George Soros holds
a “Belief in Fallibility”, which reduces guilt and transforms losses into neutral items of
interest.
c. Journaling - Record and review the thought process behind financial decisions (both
buy and sell). Ensure a non-judgemental, curious approach to prevent rumination.
MEDITA
Ques4. Identify the major criticisms of neurofinance research.

Ans. Important critiques of neurofinance address the following:

• There is a lack of experimental replication of many early findings.

• Many researchers push the boundaries of existing decision science. Rather they
should replicate the studies of colleagues so as to get more accurate results.

• Neurofinance studies are often expensive. Therefore research funds are difficult to
procure for the research.

• Sample sizes of neurofinance studies are small (20 or less) as techniques used in this
field such as fMRI are costly.

• Composition of the samples is also one of the limitations of neurofinance studies. The
subjects in these studies are typically students. Thus, these samples may not reflect
the leaning and experience of professional financial decision makers. These samples,
therefore, may not be confirmed for older individuals.

• Findings from these studies may not represent noisy real-world decision-
making.REA
Ques5. What is “realization utility hypothesis”? How cognitive
neuroscience can facilitate its empirical testing?

Ans. Economists have documented many patterns regarding how individual investor trade
stocks but less is known about the cognitive mechanisms that generate these patterns. For
example, there are various competing theories that can potentially explain the disposition
effect (i.e., the tendency to sell winning stocks more often than losing stocks). One recent
hypothesis is that investors derive utility directly from the act of selling a winning stock and
derive disutility from selling a losing stock. This is known as “realization utility hypothesis”.

“Realization utility” theory of investor behaviour hypothesizes that people derive utility
directly from the act of realizing gains and losses. This hypothesis is difficult to test using
behavioral data alone but methods from cognitive neuroscience have proved useful in testing
the theory.

The realization utility model is based on the assumption that, in addition to deriving utility
from consumption, investors also derive utility directly from realizing gains and losses on the
sale of risky assets that they own. For example, if an investor realizes a gain (e.g., by buying
a stock at $20 and selling it at $40), he receives a positive burst of utility proportional to the
capital gain. In contrast, if he realizes a loss (e.g., by buying a stock at $20 and selling it at
$10), he receives a negative burst of utility proportional to the size of the realized loss.

The presence of realization utility is important because, in combination with a sufficiently

high time discount rate, it leads investors to exhibit a disposition effect. The disposition effect
is the robust empirical fact that individual investors have a greater propensity to sell stocks
trading at a gain relative to purchase price, rather than stocks trading at a loss. This fact has
attracted considerable attention because it has proven challenging to explain using simple
rational models of trading behavior.

As a model of the decision-making process, the realization utility model makes several
predictions about the neural computations that should be observed at different points in time.

1) The realization utility model predicts that, at the moment when a subject is making a
decision as to whether to sell a stock, neural activity in areas of the brain that are associated
with encoding the value of potential actions at the time of a decision should be proportional
to the capital gain that would be realized by the trade (i.e. to the difference between the sale
price and the purchase price).

2) The realization utility model predicts that, across individuals, the strength of the
disposition effect should be correlated with the strength of the realization utility signal in the
area of ventromedial prefrontal cortex (vmPFC) that computes decision values. This follows
from the fact that a subject who is strongly influenced by realization utility should exhibit
both a strong disposition effect and neural activity in decision value areas that reflect the
computation of the associated capital gain.

3) The realization utility hypothesis states that realizing a capital gain generates a positive
burst of utility, while realizing a capital loss generates a negative one.

In a recent experiment, human subjects traded stocks while inside an fMRI scanner (Figure
A). The average subject exhibited a large disposition effect, although it was a costly mistake.
Figure B shows a spike in neural activity in the striatum on selling a winning stock. By
contrast, there was no spike in activity when the subject chose not to sell the winning stock.
This neural signal provides evidence that is consistent with the realization utility hypothesis
of the disposition effect. We speculate that there may exist similar correlations among other
well-known trading biases generated by common mechanisms.

(i) a price update screen, where (ii) a trading screen, where

subjects see news about price subjects can trade stocks
changes
Fig B: Ventral striatum (VSt) activity time locked to selling decision when given
opportunity to sell a winning stock.