Day 119 in MIT Sloan Fellows Class 2023, Financial Market Dynamics and Human Behavior 3 - "Neuroscience and Decision Making"
In today's lecture, Prof Andrew Lo explained that our neuron system is hardwired to some feelings and would make our decision better and worse depending on the situation.
Neuroscience of decision making
Various factors actually affect our decisions.
- Basic neuroanatomy and neuroimaging
- Pain/Fear and please/greed
- Rationality
- Split-brain studies
- Empathy and theory of mind(ToM)
Basic of Neuroanatomy
We started from the basics of neuroanatomy, and Prof. Lo introduced PFC(Prefrontal Cortex) as the first component affecting our decisions and differentiating us from other animals.
With fMRI, prof Lo observed how a trader's brain, mainly PFC worked when he or she traded.
fMRI allows academics to track brain activity, not a snapshot of brain activity.
https://journals.sagepub.com/doi/10.1097/00004647-200208000-00002
Pain and Fear
Pain actually protects us from long-term issues.
People really work hard to avoid pain. But do you know the feeling without pain? It would be a great experience, but you cannot return to normal senses. So you need to take care of drugs!
Pain is a neural "alarm system," and your brain reacts to physical pain and psychological pains such as social rejection. Eisenberg (2003) proved this in the exciting experiment as follows.
Does rejection hurt? An FMRI study of social exclusion
How Social Pain Hurts Our Learners - adaptED Consultants
Physical pain and social pain both activate ACC.
On the other hand, fear is a particular emotion different from any other human feeling. As the most famous example, Pavlov's dog, usually those, classical conditioning requires multiple repeated trials.
However, fear conditioning is only one time, and it would continue permanently. Many can call it traumatic.
Fear is deeply connected to Amygdala, and if you activate this part, your blood pressure jumps, and you feel something in your goosebumps. So Amygdala has a shortcut to your body, sometimes giving you some wisdom to avoid dangerous situations.
Rationality
How to define rationality?
What is intelligence?
The answer is surprisingly straightforward.
The ability to construct good narratives. In other words, the ability to generate accurate cause-and-effect descriptions of reality.
For example, in the economic context, "if X, then maybe Y" can be brilliant. So, the essences of intelligence are memory and prediction, according to Hawkins's "On Intelligence."
And this memory-prediction engine creates good narratives.
- Emotion makes people more rational. Damasio(1996)https://www.jstor.org/stable/3069187
- Brain will prioritize the brain stem, limbic system, and PFC. PFC is the first part to stop when you have trouble or fatal damage.
- Left brain is in charge of rationality(narrative). The right brain is in order of observation, attention, visuospatial processing, episodic, and no probability matching(unnecessary reasoning)
- Gift fear vs. amygdala hijack
Systematic Framework to avoid an Amygdala hijack
- What is the primary motivation for the trade/strategy?
- Why should it work?
- Why shouldn't it work?
- How can you tell?
- How long should it last?
- What is your "loss threshold"?
- When do you get back in?
- How did you go?
For example, Equity statistical arbitrage would answer the following.
- lead/lag
- over-reaction, delayed price-discovery
- decimalization, low volume, DE Shaw
- Daily P&L patterns
- From a few days to a few hours
- 3-5% MDD
- higher volatility and volume
- performance attribution(size, sectors, etc)
