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Scientific American

The Prospects for Homo economicus

published July 2007 | comments (5)
A new fMRI study debunks the myth that
we are rational-utility money maximizers
magazine cover

Imagine that your child’s private school tuition bill of $20,000 is due and the only source you have for paying it is the sale of some of your stock holdings. Fortunately, you got in on the great Google godsend and purchased 100 shares at $200 each, for a total investment of $20,000, and the stock is now at $400 a share. Should you realize your net gain by selling half of your Google stock and paying off your bill? Or should you sell off that Ford stock you purchased ages ago for $40,000 at its current value of $20,000?

If you are like most people (myself included), you would sell your Google stock and hang on to your Ford stock in hopes of recovering your losses. This would be the wrong strategy. Why would you sell shares in a company whose stock is on the rise, and hang on to shares in a company whose stock is on the decline? The reason, in a phrase, is “loss aversion,” and the psychology behind it does not fit the model of Homo economicus, that figurative species of human characterized b unbounded rationality in decision making.

Homo economicus is extinct, felled by the new sciences of behavioral economics and neuroeconomics, which have demonstrated that we are remarkably irrational creatures. Thousands of experiments in behavioral economics since Daniel Kahneman and Amos Tversky founded the field with their seminal 1979 paper, “Prospect Theory: An Analysis of Decision under Risk,” have demonstrated that most of us are highly loss averse. Specifically, most people will reject the prospect of a 50–50 probability of gaining or losing money, unless the amount to be gained is at least double the amount to be lost. That is, people feel worse about the pain of a loss than they feel better about the pleasure of a gain. Twice as badly, in fact.

Thanks to functional magnetic resonance imaging (fMRI), we now know where in the brain this effect happens. To see this science firsthand, I visited the lab of neuroscientist Russell A. Poldrack and behavioral economist Craig R. Fox at the University of California, Los Angeles, and climbed inside the cramped quarters of the magnetic tube. The MRI scanner snaps a picture of the brain every two seconds while the subject makes decisions about gambles, which are presented through goggles featuring tiny screens on which the choices are offered. Corrections for head motion are made by aligning the individual two-second images with one another; the data from all subjects are then warped together to correct for differences in brain size and shape. A statistical model is generated to show how the MRI signal should change over time in an area that responded perfectly to the task, followed by statistical tests to compare the observed data with the perfect model, resulting in statistical maps that are then converted into colorful pictures of brains in action.

In “The Neural Basis of Loss Aversion in Decision-Making under Risk,” in the January 26 Science, Poldrack, Fox and their colleagues Sabrina M. Tom and Christopher Trepel presented the results of their fMRI study, in which they offered subjects a prospect of accepting or rejecting a gamble that offered a 50–50 chance of gaining or losing money. As the potential for gains rose, they found increased activity in the mesolimbic and mesocortical dopamine systems (dopamine is a neurotransmitter substance associated with motivation and reward).

As the potential for losses increased, they found decreasing activity in these same reward-sensitive areas. Interestingly, it appears that losses and gains are coded by the same brain structures — the ventromedial prefrontal cortex, associated with decision making and learning in the context of reward and punishment, and the ventral striatum, associated with learning, motivation and reward. Individual differences in loss aversion were predicted by how much more the brain was turned off by losses than it was turned on by gains.

This effect may be caused by differences in neurochemistry, which means that some of us may be hardwired to be high- or low-risk takers, translating into real-world financial prospects, both good and bad.

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5 Comments to “The Prospects for Homo economicus

  1. Jacob Jaffe Says:

    As a psychologist, I find similar processes in the psychological realm, which determine peoples’ emotional and behavioral choices.
    I find your articles informative and thought provoking and look forward to receiving them.

  2. Gerard Lemay Says:

    How does one reconcile your risk aversion
    conclusion with the notion, which I believe to
    be true, that the promise of reward is a
    better motivator than the threat of
    punishment?

  3. Becknerized Says:

    Fascinating, but not necessarily unreasonable. It’s considerably harder to gain, say, $5000, when you have $10,000 to invest, than it would be to gain the same amount by investing $100,000. This rule of diminishing leverage makes loss aversion quite logical in the abstract. It follows that the closer any potential loss brings the subject to the point of zero leverage (no expendable assets to gamble), the more loss averse they will be. Is this borne out in the study?

    But I’m more interested in this study’s implications about free will and determinism.

  4. ray Says:

    Could this result be due to the fact that from an evolutionary perspective, ‘winning’ is usually harmless, whereas ‘losing’ may take you out of the gene pool?

  5. Christopher Alexander Says:

    I think there is more than one reasoning fallacy going on here. It is not true that selling the Ford stock is the “correct decision”. Past performance does not predict future results. Google could start going down, or Ford start going up, at any time. There is no simple formula to beat the stock market. Based on the limited information presented, both decisions are equally correct.