Reason and Emotion Drive Market Efficiency

Earlier this year I posted about our two tools for decision making, reason and emotion. Justin Landwehr recently posted a great explanation of the idea:

This is where I think the camera analogy is very useful. If you think of emotions being like the automatic settings and you think of manual mode as being like reasoning, you can ask of a photographer, "What's better: the automatic settings or the manual mode?" And what the photographer will say is "different things are good for different circumstances" -- that if you are in a standard kind of photographic situation, the kind that the manufacturer of your camera could anticipate, then go ahead and use your automatic landscape setting or whatever. But if you're facing a fundamentally new kind of photographic challenge, then you are probably going to have to put your camera in manual mode.

It seems obvious that the manual mode in our brain is helpful. We do the mental math and calculate which decisions are best. This drives producers and consumers alike. Here's a description of an experiment showing how our automatic setting can hurt and help:

Montague’s experiments go like this: A subject is given $100 and some basic information about the stock market. After choosing how much money to invest, the player watches as his investments either rise or fall in value. The game continues for 20 rounds, and the subject gets to keep the money. One interesting twist is that instead of using random simulations of the market, Montague relies on real data from past markets, so people unwittingly “play” the Dow of 1929, the S&P 500 of 1987 and the Nasdaq of 1999. While the subjects are making their investment decisions, Montague measures the activity of neurons in the brain.

Here's the big reveal:

But then Montague discovered something strange. As the market continued to rise, these same neurons significantly reduced their rate of firing. “It’s as if the cells were getting anxious,” Montague says. “They knew something wasn’t right.” And then, just before the bubble burst, these neurons typically stopped firing altogether. In many respects, these dopamine neurons seem to be acting like an internal thermostat, shutting off when the market starts to overheat. Unfortunately, the rest of the brain is too captivated by the profits to care: instead of heeding the warning, the brain obeys the urges of so-called higher regions, like the prefrontal cortex, which are busy coming up with all sorts of reasons that the market will never decline. In other words, our primal emotions are acting rationally, while those rational circuits are contributing to the mass irrationality.