07/20/2009 05:12 am ET | Updated May 25, 2011

This Is Your Brain On Wall Street

What does a stock trader have in common with a cocaine addict anticipating a fix?

A lot, when you're looking at functional MRI scans of their brains. In both cases, red and yellow embers light up the nucleus accumbens, the command center for anticipating reward.

Ah yes, Daddy D has begun its mass hijacking...

Pioneers in the field of neurofinance are searching for the right neurococktail of emotion and logic for today's fast-paced electronic marketplace. They have discovered that the allure of making money can hijack traders and investors into states of mania similar to a gambler's high. Alan Greenspan called it irrational exuberance.

It's all about the dopamine, says That's the feel-good neurotransmitter that gushes into the bloodstream when reward is imminent. Attaining the reward ignites a milder glow of satisfaction in the medial prefrontal cortex -- no match for the fireworks of anticipation -- and that's the catch.

Driven By Emotion
Dopamine has inflated economic "bubbles" since Holland went mad for tulips. Now neuroscientists are turning up more subtle pitfalls in the gray matter.

For example, when a stock price goes up twice in a row, the brain detects the pattern and "automatically, unconsciously and uncontrollably expects a third repetition," writes Jason Sweig, author of Your Money & Your Brain. Similarly, the brain tracks patterns of successful behavior and subconsciously replicates them -- which is why we follow our instincts. But when an investor makes money on a foolish hunch, then scores again the same way, the emotional brain latches onto the so-called "strategy" against all logic.

Add to that the tendency to take credit for successes which are, in fact, random events. After several impressive gains, the caudate may signal, "I'm in control!" This causes a surge of confidence which is as illusory as believing you made it rain (and you can do it again).

When Fear Sets In
On the flipside, "busts" occur when fear trips the cerebral wiring designed to protect us from loss. Says Sweig: the prospect of losing money triggers biochemical changes that have "profound physical effects on the brain and body." The organism hunkers into survival mode, and that's a good thing -- sometimes. But for investors, fear reactions can distort logic and skew risk assessment, pushing even seasoned traders to seek safety where none exists, or get cold feet and sell too soon.

Financial institutions in the U.S., Britain, Germany and Switzerland are banking that brain research will produce the uber-trader. But how will it affect the small investor?
Next Post: Investor, Know Thy Brain

For more information, see:
Brainethics: Readings in Neuroeconomics.
Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich by Jason Zweig,
Inside the Investor's Brain: The Power of Mind Over Money by Richard L. Peterson