This week David Edwards will explain in a three part series the basics of neurofinance, its history and potential practical applications.

What is Neurofinance? by David Edwards

Neurofinance is a new science that analyzes financial markets by applying neurotechnology to trading behavior. The goals of neurofinance are:

1) to improve trading results and our understanding of financial markets by identifying which physiological traits affect trading behavior

2) to correlate these traits with trading success (or failure), and

3) to develop tools, technology, and training methods to improve trading performance.

Neurofinancial theory holds that our inability to behave rationally is rooted in our psychophysiology. Because neurofinance is based on the assumption that individuals have varying psychophysiological make-ups, which in turn play a strong role in both their ability to make rational decisions and in their success as financial market operators, it represents a contrary approach to that of the efficient market hypothesis (“EMH”). EMH, the theory upon which most of modern finance is based, as well as its antecedent, utility theory, contain the implicit precondition that humans generally act out of rational self-interest, and will behave accordingly when faced with economic decisions. In other words, that people will make the most rational and efficient economic choice no matter the situation or conditions. We all know, of course, that in real life, this is not always the case. The question is why?

More Focused than Neuroeconomics

Though neurofinance is still in its infancy, its ancestors and cousins include behavioral finance, behavioral economics, behavioral game theory, and neuroeconomics. While the first three have employed concepts from the behavioral sciences, in particular social psychology, the later has relied on neuroscience techniques that image brain activity, such as PET scans and fMRI.

One way of looking at the difference between the behavioral approach to finance and economics and the neuroscientific approach, is that the former observes how people act and interact when they make economic or financial decisions and interprets these actions according to established psychological concepts, while the later investigates why these behaviors occur based on our brain and hormonal activity.

What distinguishes neurofinance from neuroeconomics, though they use many of the same techniques, is that while neuroeconomics seeks to understand the physiological basis for making economic decisions, neurofinance focuses more narrowly on trading and financial markets.

On Wednesday David will explore some potential research areas in neurofinance.