Taking the risk out of decision-making
Monday, May 23, 2016, 06:50 AM | Source: Pursuit
By Peter Bossaerts
Think about the last time you were faced with making a decision – a decision that felt 'risky'. Was the decision you made based on gut instinct, emotion or imagining what a friend or relative would do in the same situation?
Our ability to make choices can be affected by observing how and why other people are responding in that critical moment of decision-making. In financial and economic markets this is called the contagion effect. It explains the link between financial decision-making and how the behaviour of others influences our assessment of risk.
"Contagion is the effect of one person making risky decisions, say to buy property, and other people's decisions to flock to the market, creating a 'housing bubble'," says Peter Bossaerts, Professor of Experimental Finance and Decision Neuroscience at the University of Melbourne.
"The effect of such contagion can indirectly affect people not actively involved in property investment," he says, singling out apartment owners or tenants, and even the construction industry.
A joint University of Melbourne and California Institute of Technology study on neural activity at the moment a decision is being made offers a new perspective on how individuals view risk. Extending beyond the traditional theories of biology, physiology and economics theory, these findings answer the question of why we sometimes adopt 'risky' behaviour and why at other times we don't.
The research paper, Behavioural contagion during learning about another agent's risk preferences acts on neural representation of decision-risk is published by the Proceeding of the National Academy of Sciences of the United States of America (PNAS).
Based on experimental trials, the researchers found that the chances of someone making a risky decision, and their 'risk preference', can change depending on the outcome they see when watching others faced with the same choice.
"An individual's attitude towards risk can exert a profound influence on his or her life in a wide array of contexts," says Professor Bossaerts.
The paper is based on a study conducted using a combination of neuroimaging and computational modelling. It involved asking participants to make a choice between taking a guaranteed $10, or gambling to receive either more or less.
Participants subsequently observed others being asked to make the same choice, and were then asked to predict what choice new participants would make.
The results from the experimental trials confirm that an individual's risk aversion when facing a financial decision can indeed change, depending on what others do. By carefully analysing signals in the brain to measure our perception of 'risk versus reward', Professor Bossaerts' research confirms that people felt that to gamble on the money was a less risky option once they had seen others make the same choice and seen the outcome.
So can neuroeconomics change future thinking?
While Professor Bossaerts designed the experimental trials in a way that can ultimately teach people how to improve decision-making in the future, specifically in regards to financial risk, they are not meant to replace our intuition. "Gut instinct can be good," says Professor Bossaerts. "In general, emotions are an integral part of reasoned risky decision-making."
He believes that the area of neuroeconomics "is a necessary, contemporary biological approach able to highlight not only where decisions are being made in the brain, but how those decisions are being made".
"We have accomplished what traditional behavioural finance could not," says Professor Bossaerts. "By going beyond behaviour to understand computations in the brain, we have been able to determine the true causes of financial contagion.
Neurobiology becomes an integral part of the study of financial decision-making.
His research highlights the value of shifting traditional economic thinking on risk preference from a how decisions are being made perspective to a where are decisions being made point of view. However "experiments are not the opposite of theory", says Professor Bossaerts. "Experiments are to be compared against traditional empirical methodology, which has been to test theory on historical data from the field."
For those working within financial industries, such as stockbrokers and trade investors, the field of neuroeconomics and the principles behind contagion may help them manage existing cognitive biases that influence everyday financial decisions, and so apply rational thinking to their choices.
The findings also have relevance beyond the world of finance and economics. For example, adolescent behaviour is known to be strongly influenced by peers, although it is not known how this influence operates. "Casual evidence tells [us] that we are affected substantially by peer pressure," says Professor Bossaerts. This is also what happens in a housing bubble.
While there is no solid data that records the average number of decisions we make over our lifetime as a result of peer influence, the work of Professor Bossaerts and his collaborators suggest that peer influence is an important part of risk assessment and the decisions we make.
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