By Kabir Sehgal, the author of Coined: The Rich Life of Money And How Its History Has Shaped Us. He is a former vice president at an investment bank.

Can brain scans predict the market?

Im not good at predicting the market. At first, I thought it was just me. In 2008, I began working in sales and trading at an investment bank. I lacked formal training in fundamental security analysis, and my projections rarely matched actual outcomes. Yet it wasnt until the great financial crisis that I realized that even well-trained professional forecasters can get it incredibly wrong. That the IMF, Fed, and several asset management firms and investment bank research departments didnt see the crisis coming left me with a question: is there a better way to forecast? I searched for answers for several years while I researched my book Coined: The Rich Life of Money And How Its History Has Shaped Us. I eventually concluded that if we want to become better at financial forecasting, we shouldnt just consult stock charts but brain scans.

Homo economicus, an efficient, rational, calculating machine, never worries about complexity. But Homo sapiens is an entirely different creature. We humans are poor and biased calculators. We regularly succumb to fads, fancies, and passions. We can be fooled.

In one study, the behavior of over 400 people in an affluent community was analyzed. These are supposedly self-interested people who built considerable wealth. Yet only seven percent of these people acted in a manner similar to homo economicus. In the words of quantitative finance expert Paul Wilmott, Economists models are just awful. They completely forget how important the human element is. Nassim Nicholas Taleb puts it more emphatically, We have to build a society that doesnt depend on forecasts by idiotic economists. Maybe the idiocy of which he speaks is that weve long made assumptions about human behavior with little scientific basis. But increasingly, neuroscientists can provide scientific insights into how we make financial decisions.

Brain Economics

It was late at night, but I was wide awake. I was browsing YouTube and came across a lecture of Brian Knutson, a neuroeconomist at Stanford University. Neuroeconomics is an interdisciplinary field, but its essentially comprised of neuroscientists who study how humans make financial decisions. In the lecture, Knutson explained how he could accurately predict whether someone would buy or sell a stock by scanning their brain. Moreover, he described how genes influence our investment decisions. I wasnt just fascinated with the accuracy of his forecasts. But that he was establishing a biological basis for financial forecasting. He started with the brain and then looked at the resulting financial decisions instead of just assuming that we acted in line with a theory of human behavior.

I wanted to learn more, and so did my friends who are professional investors. So I invited Knutson to New York to meet with us, and he obliged. He walked us through some of the key findings of his research:

Genes influence financial decisions

Ive heard portfolio managers make many excuses about their poor performance. But Ive never once heard one say, Sorry for losing you money. Im genetically predisposed to taking on more risk despite market conditions. But in a study, Knutson and two colleagues found that genes indeed influence our financial decisions. They found that there are variants of the 5-HTTLPR gene that influence how much risk someone will take. For example, participants who had one variant with short alleles took on less risk, placing more money in cash than equities. They also had significantly higher FICO scores and fewer credit lines. In other trials, researchers have found that identical twins make similar investment decisions, even when they are separated. It seems that our financial decisions are shaped, in part, by our genes.

Brain scans predict financial choices

Knutson has used brain scans to predict many different types of financial decisions, from shopping to investment choices. In a study, he scanned the brains of consumers as they were shown different consumer products. He found that the nucleus accumbens, a reward region in the brain, fires when a product is displayed. However, the insula, a fear region of the brain, activates when consumer thought the price for the product was too expensive. He found that indeed neural activity accurately predicted the eventual consumer choice. In another study, he found that activity in the nucleus accumbens predicted whether someone bought a stock. Whereas activation in the insula meant that someone would make a more conservative decision, like buying a bond.

Its one thing to predict one persons shopping or investment decisions. But can brain scans be used to forecast the entire market? Neuroeconomist Paul Glimcher says, If we had access to that data, when people pick stocks, can these models predict macro-level changes in stock prices from individual-level models of angels picking stocks? Theres reason to believe it might work. Already, neuromarketing consultancies advise large companies like Google and PepsiCo on which products will do well, and how to position them in the marketplace. Maybe one day there will be boutique equity research consultancies that scan the brains of focus group participants as they answer questions about individual securities, and investors could incorporate these neural inputs as they mull whether to buy or sell a security.

By scanning the brains of humans, Knutson has dispelled the notion that we are homo economicus and that we are indeed complex homo sapiens, driven not just by logical and rational forces but emotional and hormonal ones. We dont just make financial decisions with the prefrontal cortex, the part of the brain involved in higher faculty, logical thinking. Instead, brain scans show that the reward and fear regions of the brain are deeply involved in how we make financial decisions. While were still many years away from the day when investors incorporate brain scans into their forecasting methodology, neuroeconomics has given us a more realistic model of human behavior.

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