Now we know why most investors act like lemmings. But will we change the way we act next time the crowd rushes to buy or sell? From the Wall Street Journal:
From February through May, the Dow Jones Industrial Average gained more than 1000 points in an almost uninterrupted daily march upward. Then came the “flash crash” of May 6 and day after day of losses through May. Now, in mid-June, the market has been up six of the past seven days.
What accounts for these sudden moves? Why do investors so often seem to resemble a school of fish, all changing direction together?
Sometimes the most interesting answers to financial questions come from scientific labs. A study published last week in the journal Current Biology found that the value you place on something is likely to go up when other people tell you it is worth more than you thought, and down when others say it is worth less. More strikingly, if your evaluation agrees with what others tell you, then a part of your brain that specializes in processing rewards kicks into high gear.
In other words, investors often go along with the crowd because—at the most basic biological level—conformity feels good. Moving in herds doesn’t just give investors a sense of “safety in numbers.” It also gives them pleasure.
That may help explain why market sentiment can change so swiftly, why true contrarians are so hard to find and why investors care so much about the “consensus view” on Wall Street.
In the experiment, researchers from University College London and Aarhus University in Denmark asked 28 people to submit a list of songs they wanted to buy online and then to decide which they would most like to own. Then the participants viewed the ratings of the same songs by two professional music experts. Meanwhile, a magnetic resonance imaging machine recorded the patterns of activity in their brains. Finally, as a way to measure the influence of the experts’ views, the participants had the chance to change their minds about which songs they wanted the most.
The brain scans showed that as soon as people learned they had chosen the same song as the experts, cells in the ventral striatum—a reward center wired with dopamine neurons that respond to pleasures like sugar and sex—fired intensely…
[continues in the Wall Street Journal]