Neurophysiological evidence on perception of reward and risk: Implications for trading under time pressure

Recent neurophysiological studies reveal that risk and reward are separately encoded in the human brain, and that the encodings display different timing patterns. Therefore, we hypothesized that sensitivity of trading decisions to risk and reward parameters would differ depending on time pressure. Consistent with this prediction, we find that decisions under extreme time pressure (1s delay time, with decision to be made in next 1s interval) reflect preference for expected reward and aversion to variance and skewness. With less time pressure (3s or 5s delay before decision), variance sensitivity disappears; sensitivity to expected reward remains the same and sensitivity to skewness increases. Buying impulsiveness emerges under extreme time pressure (subjects buy at higher prices, ceteris paribus), but is fully offset when more time is available. Prospect-theoretic preferences can capture decisions under extreme price pressure (including buying impulsiveness), but classical smooth expected utility preferences (constant relative and absolute risk aversion) cannot. Because choices reveal aversion to skewness but no aversion to variance, choices under less time pressure are inconsistent with either classical preferences or prospect theory. Our findings have implications for trading platform (market microstructure) design, incentives contracts, and for program trading.

Demystifying Rational Financial Decision-Making

Anjali Devi Vanapilli Nursimulu

Is the human brain wired for wealth? The setting is the high-velocity financial environment. Undoubtedly, the development of sophisticated derivative instruments has improved the allocation of risk across economies, highlighting the nexus between banking and finance and economic development. But bouts of irrational exuberance raise concerns about the unprecedented pace of financial innovations. The recent past has witnessed the rapid growth of algorithmic and automated trading as competitive strategies to capture gains, for example, from zero-latency trades. At the same time, financial headlines have been set ablaze by behavioral treatises related to our evolutionary hardwiring for such emotions as greed and fear; seemingly, we are not predisposed to make rational financial decisions. This research takes a step back and explores to what extent the human brain is well adapted to assess risk and reward in financial markets. The research implemented three novel behavioral experiments, one of which used high resolution electrical neuroimaging and is organized along two distinct themes that relate to specific features of financial trading. The first theme concerns the speed of financial decisions. Are decisions made under short time constraint more likely to be biased than under less time pressure? How fast does the brain process financial information? The second theme is (financial) volatility. To what extent are individuals adept at making financial forecasts? The dearth of knowledge on these topics prompted the inductive and transversal bent of this research. Several new insights emerged that challenge the behavioral views of financial decision-making. First, fast decisions as observed on the trading floor is well-captured by moment-based theory, a workhorse of Classical Finance. This is in marked contrast to the generally accepted view that fast decisions impose a bound on rationality; rational decisions are assumed to take time-to-build. Surprisingly, biases loom larger with longer decision time. Second, analysis of electrical brain signals indicates that the brain is very fast at extracting complex monetary reward features from the environment. The behavioral and electrophysiological findings highlight the need to better calibrate the speed of decisions. Third, decision-making (here, learning and forecasting) may go awry when individuals face financial volatility; but not always. The overall findings lead to the proposition that the border between rational and irrational financial decisions is much more razor-thin than opined by behaviorists. The research paints a complex picture about how emotions affect decisions. High emotional quotient and long investment time horizon respectively distinguishes professional traders and long-term investors from novice traders and investors chasing short-term gains; the latter two groups are more likely to react emotionally. Real experts in high-velocity environments are rare and forecasts are bound to be imperfect; algorithmic and automated trades are important aids to diverse players in financial markets. Last but not least, extrapolating from the findings, regulatory policy should concern the transparency of financial products and technology-enabled trades and preferential access to trading platforms. Financial institutions, on the other hand, ought to review their business models paying particular attention to their reward system.

EPFL2011

Risk and Reward Preferences under Time Pressure

Anjali Devi Vanapilli Nursimulu

Financial decision making under time pressure, though ubiquitous, is poorly understood; classical and behavioral finance are silent about the time required for a decision to be made. In an experiment, calibrating allowable decision times to 1, 3, and 5 s, we find that classical moment-based preferences reflect time-invariant sensitivity to expected reward, purchase impulsiveness under extreme time pressure, and decreased aversion to variance and increased aversion to skewness with decision time. These timevarying sensitivities translate into increased probability distortions and decreased risk aversion for gains under prospect theory (PT). Strikingly, moment-based theory provides a better fit than PT.

Oxford Univ Press2014

Demystifying Rational Financial Decision-Making

Anjali Devi Vanapilli Nursimulu

EPFL2011