The Brain Science Behind Bubbles

It’s no secret that investors can behave quite strangely during market manias. But a new study that looks at the science of the brain takes a stab at exactly why they do so.

The study, performed by California Institute of Technology researchers, examined why bubbles form in asset prices. They found that people are more likely to make irrational decisions when they attempt to predict how others will behave, which is what happens during bubbles. “In a bubble situation, people start to see the market as a strategic opponent and shift the brain processes they’re using to make financial decisions,” Benedetto De Martino, a co-author of the study, explained, according to Yahoo! Finance’s Daily Ticker. “They start trying to imagine how the other traders will behave and this leads them to modify their judgment of how valuable the asset is. They become less driven by explicit information, like actual prices, and more focused on how they imagine the market will change.”

The researchers used brain scans of study participants, who were investing in an experimental bubble market, to reach their conclusions. “The ability to infer intentions of other agents, called theory of mind (ToM), confers strong advantages for individuals in social situations,” they wrote. “Here, we show that ToM can also be maladaptive when people interact with complex modern institutions like financial markets. We tested participants who were investing in an experimental bubble market. … We describe a mechanism by which social signals computed in the dorsomedial prefrontal cortex affect value computations in ventromedial prefrontal cortex, thereby increasing an individual’s propensity to ‘ride’ financial bubbles and lose money.”