Neuro-economics: the missing link in today's financial crisis?

So, what inflicted this crisis? Or, at the very least, what were the major contributing factors?
by Tala Ramadan

27 January 2020 | 16:05

Source: by Annahar

  • by Tala Ramadan
  • Source: Annahar
  • Last update: 27 January 2020 | 16:05

A man counts Lebanese pounds at an exchange shop, in Beirut, Lebanon (AP Photo)

BEIRUT: As the compounding financial crisis begins to look like a full-blown crash, fingers are continuously pointing at poor regulations, malicious bankers, morally bankrupt politicians, and the like. While these are major elements, as the days go on, we find that there may be other elements that the eye does not see.

So, what inflicted this crisis? Or, at the very least, what were the major contributing factors?

Answers to these questions may just very well be rooted in the psychology that dictates our actions in a baffling and uncertain manner, including our aspirations, cognition, emotions, culture, and perceptions of fairness.

Turning to behavioral finance and neuro-economics

One of the crucial insights offered by neuro-finance is centered around how to reconcile classical and behavioral finance by showing that emotions are critical to rational decision-making, in spite of also being part of the origin of biases. They also signal that recessions often last longer than they should because many people are hit with negative financial shocks simultaneously, which results in becoming overly pessimistic about can be achieved by investing in new ideas, new businesses, or in their own human capital.

Hilda Kammoun, an author and specialist in neuro-economics and behavioral finance shared with Annahar the over-arching theme of trying to understand how people make financial and economic choices that concern them as individuals.

Kammoun explained that the central focus in both behavioral and rational theories of financial decision making is on the tradeoff between risk and return.

Neural cognitive and affective processes influence our financial decisions

According to Kammoun, financial decisions become financial acts when they pass the bottleneck in the upper brain stem below which all the motor neurons are available. The information flowing in the neural channels including the brain stem (mostly automatic, effortless, not reflective) and the cortex (slow, scrutinizing) are thoughts and their companion feelings. They are divided into cognitive and affective, conscious and unconscious (automatic) mostly depending on where they are generated in the brain. Thus, we are aware of our conscious thoughts and conscious feelings but we may not be aware of what really motivates or triggers them unconsciously, a process called rationalization.

What follows is an example of how the unconscious affects the conscious. Financially when you buy a stock then it starts losing you may decide to keep it because you believe it will shoot up. It could be you have objective reasons but it is also possible you are justifying your decision because you are loss averse and you would rather take more risk in order not to realize your losses. Loss is painful and you want to avoid it. Loss aversion and the propensity to take more risk in order not to realize your losses affect financial decisions unconsciously.

Neuro-finance revolutionizing the way we implement our financial modeling

The methodology used in neuroeconomic theory has two advantages. Primarily, evidence from the brain sciences provides precise guidelines for the constraints that should be imposed on decision-making processes. Kammoun explained that in order to choose rationally under risk and uncertainty we make scenarios, organize them in decision trees calculate the expected utility of each and choose the highest. Behavioral finance has changed that by introducing loss aversion, a reference point, a subjective utility, and probability function. Neuroscience findings favor the state-dependent system because of homeostasis.

This can help uncover the "true" motivations for the "wrong" choices and improve the predictive power of the theory.

Driving our finance with revision and adaptation to different scenarios, and adjust our repetitive decision-making contexts through neuro-finance understanding

Kammoun shared tips with Annahar on how one can revise and adapt to different financial scenarios and how we should understand how our attitudes for risk is related to preference or reward.

“Think of yourself as a state-dependent system where the system is effective dependent on prior affective states, on the external stimulus -in the immediate and its stronger marginal effect- the internal knowledge and the autobiographical reflective self,” Kammoun told Annahar.

People who are aware of their financial illiteracy and want to seek financial advice can read the following recommendations: Colin Camerer et al. Neuroeconomics: How can neuroscience inform economics, The intelligent investor. And finally, since a mistake of illiteracy is to invest in an actively managed portfolio, Hilda Kammoun’s book “Think with Your Wallet: Ever Upward” warns against that. 

Show Comments

An-Nahar is not responsible for the comments that users post below. We kindly ask you to keep this space a clean and respectful forum for discussion.