15.

481 Financial Market Dynamics

and Human Behavior
Andrew W. Lo, MIT
Unit 4: Neuroscience and Decision Making
Lecture: Rationality
Rationality
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Prefrontal Cortex (PFC)
Higher Thought (Uniquely Human Behaviors)
§ This region was damaged in Phineas Gage
§ Planning, goal-oriented behavior, “executive function”, logical
deliberation, abstract thoughts
§ Serial integration of information from
other components (limited capacity)
§ Is this where rationality and
Homo economicus resides?

Source: Davidson and Irwin (2000)

© 2020 by Andrew W. Lo
Lecture 4 Slide 3
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 15.481
Rethinking Rationality
Patient Elliot Had Frontal Lobe Damage:
§ No Impact on IQ or Logical Functions
– Perceptual Ability
– Past Memory
– Short-Term Memory
– Learning
– Language
– Arithmetic
§ But Behavior Was Quite Irrational!
© 2020 by Andrew W. Lo
Lecture 4 Slide 4
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 15.481
Rethinking Rationality
Damasio (1994, p. 36):
When the job called for interrupting an activity and turning to
another, he might persist nonetheless, seemingly losing sight
of his main goal. Or he might interrupt the activity he had
engaged, to turn to something he found more captivating at
that particular moment… The flow of work was stopped. One
might say that the particular step of the task at which Elliot
balked was actually being carried out too well, and at the
expense of the overall purpose. One might say that Elliot had
become irrational concerning the larger frame of behavior…

© 2020 by Andrew W. Lo
Lecture 4 Slide 5
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 15.481
Rethinking Rationality
MulAple Components Interact To Produce Behavior
§ But components don’t have the same priority
§ “Gi4 of fear” vs. “amygdala hijack”
§ Examples:
– Forced smile vs. natural smile
– Being too flustered to speak (anger/maVng)
– Stroop (1935) task
– Road rage
© 2020 by Andrew W. Lo
Lecture 4 Slide 6
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 15.481
The Stroop Task
Say the colors of the following word:
RED GREEN BLUE YELLOW ORANGE

BLUE BROWN RED GREEN PURPLE

PINK BLACK BLUE YELLOW GREEN

© 2020 by Andrew W. Lo
Lecture 4 Slide 7
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 15.481
The Stroop Task
Say the colors of the following word:
RED GREEN BLUE YELLOW ORANGE

BLUE BROWN RED GREEN PURPLE

PINK BLACK BLUE YELLOW GREEN

© 2020 by Andrew W. Lo
Lecture 4 Slide 8
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Road Rage: Benchmarking the PFC
4 ´ 286 = _____ 3 ´ 727 = _____
2 ´ 516 = _____ 5 ´ 679 = _____
7 ´ 124 = _____ 2 ´ 129 = _____
8 ´ 328 = _____ 6 ´ 457 = _____
2 ´ 697 = _____ 8 ´ 342 = _____
9 ´ 713 = _____ 7 ´ 643 = _____
6 ´ 833 = _____ 4 ´ 179 = _____
4 ´ 427 = _____ 9 ´ 234 = _____

Lecture 4 Slide 9
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Road Rage: Stimulus

http://www.youtube.com/watch?v=NEEirHFbfdg
© 2020 by Andrew W. Lo
Lecture 4 Slide 10
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Road Rage: Benchmarking the PFC
2 ´ 627 = _____ 9 ´ 154 = _____
3 ´ 214 = _____ 2 ´ 724 = _____
7 ´ 729 = _____ 5 ´ 313 = _____
9 ´ 118 = _____ 3 ´ 143 = _____
4 ´ 534 = _____ 7 ´ 964 = _____
5 ´ 388 = _____ 6 ´ 234 = _____
8 ´ 312 = _____ 2 ´ 363 = _____
3 ´ 377 = _____ 8 ´ 125 = _____

Lecture 4 Slide 11
Split Brain Studies
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Lateralization of Brain Function
Split-Brain Experiments:
§ Roger Sperry and Michael Gazzaniga (late 1950s– )
§ Corpus callosum connects brain hemispheres
§ Severed in patients with intractable epileptic seizures
Corpus callosum: Latin for “tough
body”

250 million interconnections

between the left and the right
hemispheres of the brain
© 2020 by Andrew W. Lo
Lecture 4 Slide 13
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 15.481
Lateralization of Brain Function
Split-Brain Experiments:
§ Eyes are cross-wired to opposite hemispheres
§ Each hemisphere interprets data independently
§ Subjects get no conscious knowledge from the left
eye
§ Right hemisphere unable to describe what it
sees
§ Left hand can still point!
Sperry (1968)
© 2020 by Andrew W. Lo
Lecture 4 Slide 14
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 15.481
Lateralization of Brain Function

© 2020 by Andrew W. Lo
Lecture 4 Slide 15
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 15.481
Lateralization of Brain Function

© 2020 by Andrew W. Lo
Lecture 4 Slide 16
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 15.481
Lateralization of Brain Function

“Chicken goes with the chicken foot”

“Shovel used to clean chicken coop”

© 2020 by Andrew W. Lo
Lecture 4 Slide 17
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Lateralization of Brain Function
Left Brain
§ Interpretation (narrative)
§ Linguistic and semantic ability
§ Sense of self and purpose
§ Executive function
– Planning, hypothesizing,
linear sense of time
§ Fooled into probability
matching
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Right Brain
§ Observation, attention,
no sense of time or self
§ Visuospatial processing
– Contours, shapes, faces
§ Episodic
§ No probability matching
– Exception: probability matching
for facial hair task (Miller and
Valsangkar-Smyth, 2005)!

© 2020 by Andrew W. Lo
Lecture 4 Slide 18
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 Empathy and
Theory of Mind
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Empathy and Mirror Neurons
“I Feel Your Pain”
§ Mirror neurons discovered
§ Allows us to feel other people’s
experiences
§ Mimicry, learning, etc.
§ Physiology of empathy
§ We actually can feel other people’s
pain, pleasure, which helps us
cooperate
© 2020 by Andrew W. Lo
Lecture 4 Slide 20
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 15.481
Empathy and Mirror Neurons

© 2020 by Andrew W. Lo
Lecture 4 Slide 21
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Empathy and Mirror Neurons

© 2020 by Andrew W. Lo
Lecture 4 Slide 22
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Empathy and Mirror Neurons
Feeling Each Other’s Pain/Pleasure Creates Market
Dynamics
§ “Hall of mirror” neurons!
§ Greatly magnifies impact of events
§ Creates shared experiences, beta!
§ Synchronized reactions, trends
§ Productive: collaboration, teams
§ Unproductive: gangs, Hitler, bubbles, crashes
But What Does This Imply For Finance?? Traders Beware!
© 2020 by Andrew W. Lo
Lecture 4 Slide 23
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