'Market bubbles leading to financial crashes may be all in traders' minds'

Drivers of financial boom and bust may be self-made because of instinctive biological mechanisms in traders' brains, which lead them to try and predict others' behaviour, a new study has suggested.

Researchers at the California Institute of Technology brought together expertise in experimental finance and neuroscience to look at the brain activity and behaviour of student volunteers as they traded shares within a staged financial market.

The researchers used functional Magnetic Resonance Imaging (fMRI), a technique to measure the flow of blood in the brain as an indication of activity, to map participants' brain activity as they traded within the experimental market.

They found that the formation of bubbles was linked to increased activity in an area of the brain that processes value judgements.

People who had greater brain activity in this area were more likely to ride the bubble and lose money by paying more for an asset than its fundamental worth.

In bubble markets, they also found a strong correlation between activity in the value processing part of the brain and another area that is responsible for computing social signals to infer the intentions of other people and predict their behaviour.

The team found that when participants noticed disparity between how much they perceived an asset to be worth and the rate of transactions for that asset, they began making poor business decisions and bubbles started to form in the market.