Imagine if somehow we could rig up a bubble detector: something
to tell investors when stock prices had reached unsustainable
levels. Would stock market crashes disappear? Or could you at least
learn to avoid them?
A professor at the California Institute of Technology thinks he
might be onto such a detector. Colin Camerer is a genius, which
isn't so unusual on the geek-packed campus of Caltech. But Camerer
is certified, having been awarded a so-called genius grant from the
MacArthur Foundation last September. The no-strings-attached
fellowships bestow a total of $625,000 on each recipient over five
years. Camerer will use the windfall to further his studies in the
emerging field of neuroeconomics, which uses magnetic resonance
imaging to analyze brain activity to better understand human
The idea of a bubble detector comes from a recent study
coauthored by Camerer in which Caltech students watched replays of
trading sessions rigged in a lab. Half of the sessions resulted in
bubble markets, in which prices significantly exceeded the value of
the asset. The Caltech students, given a stake of $60 at the
outset, were periodically asked whether they would buy, sell or
hold shares of the asset at the going price. Despite the fact that
the fundamental value of the lab-created security was easy to
calculate, based on dividend payments that decreased at regular
intervals over the sessions, some of the students got swept up in
the bubble anyway. "These kids are extremely analytical," says
Camerer. "The median math SAT score here is 800 [out of 800]. It's
hard to believe they can't count and keep track of a dividend
Scans of the students' brains found that susceptibility to
bubble markets is associated with two types of activity. One is in
the area where we make social calculations--figuring out what other
people are going to do, what they want, what they think of us.
"That supports the greater fool theory" of bubbles, says Camerer.
"It's not that these investors don't realize that in 15 minutes the
asset will be worthless. Instead, they think, Maybe I can sell [to
a 'greater fool'] and get out."
Camerer also found that the human brain seems to recognize
(probably not consciously) that a bubble market has a restless
pattern that doesn't conform to the rhythm of normal markets.
"People recognize that there's something unusual, some social
contagion that's moving prices around," says Camerer. Ultimately,
any early-warning system would include information from brain
activity, prices and trading volume, as well as chatter in social
media and the news. "I'm very optimistic about bubble detection,"
Camerer also looks to the brain to discover why investors tend
to sell winning stocks too soon and procrastinate about dumping
losers--behavior documented years ago by finance professors
Terrance Odean and Brad Barber. Camerer found that when people sell
winners, even those destined to rise further, activity flares in a
part of the brain that assigns value and recognizes rewards. "The
ka-ching feeling of locking in that profit, even though it's a
mistake, feels good," says Camerer. "The lesson is that you somehow
have to override that signal."
If you're reluctant to sell a poorly performing stock because
you think it will come back, try this test: Ask yourself if you're
willing to double down and buy more. "If your heart and brain tell
you that's dumb, that's your way of knowing you don't really think
it's going to bounce back," says Camerer.
Sounds a lot like the old Wall Street adage: Cut your losses
short, but let your profits run. Camerer says he would not be at
all embarrassed if "all we discovered is that Warren Buffett is