And here I thought it was just the Prozac generation...

http://www.boston.com/dailyglobe2/296/science/The_biology_of_irrational_exuberance_+.shtml

The biology of 'irrational exuberance'

Research finds body responds to market swings

By Gareth Cook, Globe Staff, 10/23/2001

hen Alan Greenspan coined the phrase ''irrational exuberance,'' he was cautiously telling America that investors had begun to create a stock-market bubble. He was right.

Now it looks like he might have been onto some serious science as well.

In a yearlong study at a major Boston financial company, researchers from the Massachusetts Institute of Technology and Boston University found that professional currency traders react to changing markets not just with their brains, but also subconsciously - with their whole bodies. As they sit at their desks moving millions of dollars through the financial system, their vital signs react almost instantaneously as prices dip and rise.

They are, in other words, wired to the market.

Like bond traders and stockbrokers, foreign-currency traders are paid to act rationally - to ignore the waves of emotion that consume amateur investors. Yet all of the currency traders in the new study showed a clear physiological response to what the markets did, experiencing powerful surges - jumps in blood flow, sweating - with every rally and reverse. A strong emotional reaction was clear in regions far from the rational mind.

The research, conducted by an MIT economics researcher and a neuroscientist at BU, adds momentum to a growing revolt against classical economic theories, which assume people will always make decisions by thinking and acting rationally.

A growing group of economists has been arguing that financial markets do not always behave in a rational way. They go through panicky stock-market selloffs or dramatic spikes that cannot be easily explained by reasoned behavior.

A better model, the new study's authors believe, will develop when economics can find a place for the irrational quirks of human nature. And their paper, accepted for publication in the Journal of Cognitive Neuroscience, is the first such study done outside a laboratory, opening up a new kind of research into how people actually make decisions and respond to risk.

''This is an important paper,'' said Hersh Shefrin, a professor of finance at Santa Clara University. ''These are real traders in real-life settings.''

The researchers wired traders with equipment that measures their heart rate and perspiration, and compared the results to a chart of the day's ups and downs. They did not, however, match the traders' reactions with the decisions they actually made. In other words, the study showed how their bodies reacted, but not what their brains told them to do.

But the researchers did find something surprising: After watching the results, they could gauge traders' experience level solely by how their bodies behaved as they worked. Novice traders reacted strongly. Experienced ones displayed a more even keel.

''What most surprised us was the ability to distinguish experienced traders from less experienced ones,'' said Andrew Lo, co-author of the study and director of MIT's Laboratory for Financial Engineering at the MIT Sloan School of Management.

That finding eventually could have some practical uses in the financial world. MIT is about to file a patent on the technique, which Lo said he hoped to refine so that banks could use it to screen job applicants - and perhaps, if scientists discover how the emotions affect decisions, to train and even monitor their traders.

Analysts said the research is not yet practical enough to be of any use to financial institutions. How people perceive risk is a vital area, though, for companies that invest other people's money, according to Arnold Wood, president and chief executive officer of Martingale Asset Management in Boston. If there were a better way to assess how much risk investors were willing to take on, it would be easier to construct investment portfolios tailored to their needs.

To Lo, however, it's the broader implications that drove him to the work.

''I was led to this research by force,'' Lo said, ''because the standard paradigms we use in economics and finance have not progressed.''

Classic economics assumes that people are rational and greedy, always making choices that will bring them the most expected incomes. From this assumption, economists have then been able to build elaborate, mathematically precise theories.

''At one level, the logic of economics is so rigorous, but it is built on a foundation of folk psychology that we would mock in other fields,'' said Terry Burnham, a visiting assistant professor at the Harvard Business School.

In the last two decades, a growing body of critics have been cataloguing the many ways that the classical view of ''homo economicus'' fails. Economists have observed, for instance, that a person will usually feel better off if he receives a raise - but can feel worse off if he is given a raise while a co-worker receives a larger raise.

Economists say this research, called behavioral economics or behavioral finance, has succeeded in proving that classical economics has flaws, but has failed to offer a viable alternative, causing some researchers to look for a new foundation, perhaps in biology.

To investigate the role of emotions in economic activity, Lo teamed up with Dmitry Repin, a neuroscientist at Boston University who made the research a part of his doctoral thesis. The two then approached what they describe as ''a major global financial institution'' - which participated on the condition of anonymity - about enlisting traders in currencies and interest-rate derivatives in the test.

Working last year, the team outfitted 10 employees with equipment that measures data - such as pulse rate, skin conductance, and respiration rate - that researchers know is closely related to emotion. The data only indicate when someone is having an emotional response, Repin said, not what emotion they are experiencing.

The traders were then allowed to work as they normally would, and the team recorded their responses while tracking ''market events,'' such as a sudden bump in price. All of the traders responded emotionally to the market events.

Lo said that he has been amazed at how strong an emotional link traders form with the market - and how clearly experience can change their response. He said he was demonstrating the equipment to a class when he saw one student exhibit the distinctive pattern of a more experienced trader. It turned out the student had traded bonds for several years.

It was as if her emotional circuitry, he said, had been permanently changed.

-- Anonymous, October 23, 2001