A Sequel to Cognitive Finance
Cognitive finance contends that investors’ motivation to buy/sell at the stock market is a function of three things:
* Logic (as per the Rationalists, the mathematics people)
* External Environment (as per the Behaviorists, the non-numbers people)
* The emotional brain (as per the…well, BMmers interested in OB)
I left the reader at this point in my blog,
Cognitivists……..the third gang of finance??
There are some things that have occurred to me since then. At this point, I’d like to thank the authors of “Why Men don’t listen & Women cant read maps” for filling in a few gaps. It is obvious that these three aspects are not mutually exclusive. Forget the fact that they act in concurrence to determine our reactions to any external stimuli. The second aspect also has a great influence on shaping the emotional brain.
Let me explain…Since the days of yore, great social scientists like Aristotle and Descartes have advocated the duality of brain. Our brain, just like a computer, has both a software part and a hardware part….Now, when I mentioned the emotional brain in my last blog, I might have given the impression that it is purely the hardwired part I am talking about.
Biologists have long claimed that it the the neural structure that determines how we react to situations, why men and women behave differently. Damasio (1994) conducted a study among mentally challenged people. He then compared them with more privileged people, and said that lesser neural activity in this part of the brain is responsible for this particular shortcoming in decision making…But this reverse engineering technique only offers a partial view at best.
In addition to the neural structure of the limbic brain and the amygdala, our reactions are also shaped by the software installed in them. This is precisely where cognitivists come into the picture. Several neuroscience techniques have evolved to substantiate these findings. There are several theories that concern cognitivism. They may be grouped into three generations
* Appraisal Theories
* Cognititve Architectures
* Self Regulation models
We can use the last and the latest version here….that of self regulation. It goes something like this…. Suppose this guy buys100 shares of company XYZ. Sensex rises, stock price of XYZ also rises, maybe lesser because beta is lesser than 1. This chap doesn’t even know there is something called beta… But continued exposure to the effect of Sensex on his share price conditions him to the fact that when sensex rises, my stock will rise but to a lesser extent.
Take another case. Mumbai bomb blasts… this may be captured by the rationalists by conducting event studies… Say immediately after the first blasts (when was it, 1991?), share prices fell. This chap sold shares and when the stock returned to its normal values three days later, he realized he had suffered huge losses…Now the software part of the brain compares the result of the whole sequence to his long term goals and his individual perception of success…. If his perception of being successful is to become rich, then obviously there is a mismatch between losing money and being successful.
Self regulation theory says that the external stimuli (bomb blast), this guy’s reaction to the external stimuli (selling shares) and the result of the sequence (mismatch with long term goals) are fed back into his brain. This is some kind of a learning experience. The next time stock market crashes, his behavior will depend on the external stimuli (as claimed by the behaviorists), but also by the long term learning that has occurred to him. The behaviorist school of thought ignores this aspect, calling for a more integrated view.
It has puzzled many people why experienced professionals perform better than more intelligent Ivy League fresh MBA recruits. This whole explanation provided by the theory of self regulation might come in handy! The experienced people are consciously ignorant that this principle exists. But continued exposure causes their subconscious to be aware of the effects of this principle!!! Something like how people felt about gravity before it was discovered by Newton….
* Logic (as per the Rationalists, the mathematics people)
* External Environment (as per the Behaviorists, the non-numbers people)
* The emotional brain (as per the…well, BMmers interested in OB)
I left the reader at this point in my blog,
Cognitivists……..the third gang of finance??
There are some things that have occurred to me since then. At this point, I’d like to thank the authors of “Why Men don’t listen & Women cant read maps” for filling in a few gaps. It is obvious that these three aspects are not mutually exclusive. Forget the fact that they act in concurrence to determine our reactions to any external stimuli. The second aspect also has a great influence on shaping the emotional brain.
Let me explain…Since the days of yore, great social scientists like Aristotle and Descartes have advocated the duality of brain. Our brain, just like a computer, has both a software part and a hardware part….Now, when I mentioned the emotional brain in my last blog, I might have given the impression that it is purely the hardwired part I am talking about.
Biologists have long claimed that it the the neural structure that determines how we react to situations, why men and women behave differently. Damasio (1994) conducted a study among mentally challenged people. He then compared them with more privileged people, and said that lesser neural activity in this part of the brain is responsible for this particular shortcoming in decision making…But this reverse engineering technique only offers a partial view at best.
In addition to the neural structure of the limbic brain and the amygdala, our reactions are also shaped by the software installed in them. This is precisely where cognitivists come into the picture. Several neuroscience techniques have evolved to substantiate these findings. There are several theories that concern cognitivism. They may be grouped into three generations
* Appraisal Theories
* Cognititve Architectures
* Self Regulation models
We can use the last and the latest version here….that of self regulation. It goes something like this…. Suppose this guy buys100 shares of company XYZ. Sensex rises, stock price of XYZ also rises, maybe lesser because beta is lesser than 1. This chap doesn’t even know there is something called beta… But continued exposure to the effect of Sensex on his share price conditions him to the fact that when sensex rises, my stock will rise but to a lesser extent.
Take another case. Mumbai bomb blasts… this may be captured by the rationalists by conducting event studies… Say immediately after the first blasts (when was it, 1991?), share prices fell. This chap sold shares and when the stock returned to its normal values three days later, he realized he had suffered huge losses…Now the software part of the brain compares the result of the whole sequence to his long term goals and his individual perception of success…. If his perception of being successful is to become rich, then obviously there is a mismatch between losing money and being successful.
Self regulation theory says that the external stimuli (bomb blast), this guy’s reaction to the external stimuli (selling shares) and the result of the sequence (mismatch with long term goals) are fed back into his brain. This is some kind of a learning experience. The next time stock market crashes, his behavior will depend on the external stimuli (as claimed by the behaviorists), but also by the long term learning that has occurred to him. The behaviorist school of thought ignores this aspect, calling for a more integrated view.
It has puzzled many people why experienced professionals perform better than more intelligent Ivy League fresh MBA recruits. This whole explanation provided by the theory of self regulation might come in handy! The experienced people are consciously ignorant that this principle exists. But continued exposure causes their subconscious to be aware of the effects of this principle!!! Something like how people felt about gravity before it was discovered by Newton….
Labels: Finance
posted by Rishi at
10:13 PM
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