Fear, Greed, and Financial Crises: A Cognitive Neurosciences Perspective

Historical accounts of financial crises suggest that fear and greed are the common denominators of these disruptive events: periods of unchecked greed eventually lead to excessive leverage and unsustainable asset-price levels, and the inevitable collapse results in unbridled fear, which must subside before any recovery is possible. The cognitive neurosciences may provide some new insights into this boom/bust pattern through a deeper understanding of the dynamics of emotion and human behavior. In this chapter, I describe some recent research from the neurosciences literature on fear and reward learning, mirror neurons, theory of mind, and the link between emotion and rational behavior. By exploring the neuroscientific basis of cognition and behavior, we may be able to identify more fundamental drivers of financial crises, and improve our models and methods for dealing with them. Prepared for J.P. Fouque and J. Langsam, eds., Handbook on Systemic Risk, Cambridge University Press. Research support from the MIT Laboratory for Financial Engineering is gratefully acknowledged. I thank Jayna Cummings and Hersh Shefrin for helpful comments and discussion. The views and opinions expressed in this article are those of the author only and do not necessarily represent the views and opinions of AlphaSimplex Group, MIT, any of their affiliates or employees, or any of the individuals acknowledged above. Harris & Harris Group Professor, MIT Sloan School of Management, and Chief Investment Strategist, AlphaSimplex Group, LLC. Please direct all correspondence to: Andrew W. Lo, MIT Sloan School of Management, 100 Main Street, E62–618, Cambridge, MA 02142.