Testing Theories of Investor Behavior Using Neural Data

We show that measures of neural activity provided by functional magnetic resonance imaging (fMRI) can be used to test between theories of investor behavior that are difficult to distinguish using behavioral data alone. Subjects traded stocks in an experimental market while we measured their brain activity. Behaviorally, we find that, our average subject exhibits a strong disposition effect in his trading, even though it is suboptimal. We then use the neural data to test a specific theory of the disposition effect, the “realization utility” hypothesis, which argues that the effect arises because people derive utility directly from the act of realizing gains and losses. Consistent with this hypothesis, we find that activity in an area of the brain known to encode the value of decisions correlates with the capital gains of potential trades, that the size of these neural signals correlates across subjects with the strength of the behavioral disposition effects, and that activity in an area of the brain known to encode experienced utility exhibits a sharp upward spike in activity at precisely the moment at which a subject issues a command to sell a stock at a gain. 1 Frydman, Camerer, Bossaerts & Rangel are at Caltech; Barberis is at the Yale School of Management; Bossaerts is also at the Swiss Finance Institute. We are grateful for comments from participants at the Society for Neuroeconomics, the Fall 2010 NBER Behavioral Finance meeting, the 2010 Miami Finance Conference, the 2011 BEAM Conference, and the 2011 WFA Conference. Financial support from the National Science Foundation (A.R., C.C., C.F.) and the Betty and Gordon Moore Foundation (A.R., C.C.) is gratefully acknowledged.