05/04/2009 06:01 pm ET Updated May 25, 2011

Neurofinance: Gaming the Human Brain?

Wall Street has come up with a new twist on "insider trading" -- brain science.

Welcome to neuroeconomics and neurofinance -- controversial fields of research that give new meaning to the term, Pandora's Box.

For more than a decade, the advertising industry has used functional MRI (fMRI) and other imaging technologies to probe the consumer's brain. Inevitably, neuroscientists (often under contract to financial institutions) are hooking electrodes to the skulls of investors and traders, and monitoring their subconscious responses to risk and reward.

They will tell you it's all about helping investors avoid emotion-driven mistakes. But there may be a flipside. Like an ATM pin number, the neural "code" that triggers financial decisions could prove dicey in the wrong hands.

Betting on Brain Scans
Savvy traders have already leveraged research from a branch of psychology known as behavioral economics. For example, Bloomberg reported in 2004 that Arrowstreet, a $4.4 billion investment firm, had developed quantitative models to "identify and exploit" incidents when investors 1) overreact to news, 2) follow the herd, or 3) fail to account for new information.

Now, Big Finance is prowling the limbic system, a primitive slab of gray matter linked to emotions like pleasure, greed, fear, and cravings -- which begs the question, why?

The 2008 bestseller, Buyology provides an explanation:

"Finance and economic research has hit the wall," explains Andrew Lo, who runs AlphaSimplex Group, a Cambridge, Massachusetts hedge fund firm. "We need to get inside the brain to understand why people make decisions."

Neuromarketing guru Martin Lindstrom, the author of Buyology, goes a step further:

...economic modeling is based on the premise that people behave in predictably rational ways. But...what's beginning to show up in the fledgling world of brain scanning is the enormous influence our emotions have on every decision we make.

Gaming the Brain?
On one hand, Wall Street's fascination with human emotions reflects the nature of the global electronic marketplace. Gone are the days when investors bought "a piece of the rock" and kept the certificates locked in bank vaults. Today, the fast money bets on moment-to-moment fluctuations, and traders profit on both the dips and spikes. In this casino-like atmosphere, profit often derives from winning transactions, not brick and mortar valuation and growth.

Add millions of small investors on home computers reacting to media sound bites, and it's easy to see why investment firms which once focused on fundamentals and analytics are shifting their attention to the cerebral neurons that trigger the "buy" and "sell" orders.

Is it a smart defensive strategy, or the ultimate offensive maneuver?

In 2007, Caltech"s Peter Bossaerts was recruited to conduct brain scans at the Swiss Federal Institute of Technology. Funded by government grants and the Swiss banking industry, Switzerland's research in "financial engineering" is all about maintaining a competitive edge.

As Bossaerts says of neurofinance:

There is a rich future for this field, as there are many links between financial decision-making and addictions to gambling, cocaine, amphetamines...They use the same parts of the brain.

Next Blog: This is Your Brain on Wall Street: Risk, Reward and the Electronic Casino