Now consider another choice, between C and D. Option C is a sure loss of £750,000. Option D is a gamble with a 25 per cent chance of nothing and a 75 per cent chance of losing £1m.
If you're like most people, you will choose A over B and D over C. That is, faced with a gain you prefer the certain option, but faced with a loss you're prepared to gamble.
If this seems reasonable, it is not. To see why, look at what happens if we combine these choices. The combination of A and D gives us a 25 per cent chance of getting £240,000 and a 75 per cent chance of losing £750,000. However, the combination of B and C gives us a 25 per cent chance of winning £250,000 and a 75 per cent chance of losing £750,000.
Clearly, the combination of B and C is better than the combination of A and D. But most people choose A and D. Which is irrational.
It seems as if our brain is behaving in two different ways. Faced with gains, it tells us to choose safety. Faced with losses, it tells us to gamble.
In fact, neuroscientists have discovered that this is exactly what does happen. Camelia Kuhnen and Brian Knutson, two researchers at Stanford University, used fMRI scanners to see what happens in the brain when people make investment decisions. They found that when people choose between risky assets with the prospect of profits, there is high activity in the nucleus accumbens, the part of the brain associated with processing rewards and pleasure. However, when they considered risk aversion and the possibility of losses, a different part of the brain was stimulated – the anterior insula, a region associated with feelings of pain and disgust. "Risk-seeking choices and risk-averse choices may be driven by two distinct neural circuits," they conclude.
This suggests there is a neurological basis for one of the more common errors that investors make. This is the tendency to hold onto losing assets in the hope of getting even while selling winners to book profits - what economists call the disposition effect. Disgust and pain at the prospect of losses cause us to gamble in the hope of avoiding them - so we hold onto falling shares - while the desire to lock in the pleasure of profit make us cautious about holding winning shares.
This is not the only example of how neuroscience is helping to illuminate what happens in our brain when we make investment decisions. Researchers at the University of Cambridge provide another example. They've found that traders who had higher testosterone levels in the morning made higher profits that day – because testosterone emboldens men to take risks which (in their sample anyway!) pay off on average.
Unfortunately, such research shows both how hard it is for investors to behave rationally and how hard it is to predict their behaviour.
Andrew Lo of the Massachusetts Institute of Technology says that financial profits work rather like cocaine; both release dopamine into the nucleus accumbens. And this, he says, raises the possibility of a positive feedback loop. Profits release dopamine, which give us a buzz that encourages more risk taking. In this sense, the process whereby good economic times encourage excess risk taking and speculative bubbles is similar to the way in which some people get addicted to gambling.
You might object that there's a contradiction here. First, I've pointed out that there's a neurological basis for people being risk averse about profits and booking their gains too soon. But now I'm talking about positive feedback whereby profits lead to more risk taking.
In fact, there's no contradiction. It's just that there are two different mechanisms. Sometimes the dopamine effect of profits is strong enough to offset our tendency to sell past winners, and sometimes it isn't. When it is, we get speculative bubbles. And when it isn't, we get price stability. We can't tell in advance which mechanism will dominate; it's hard enough studying individual brains in real time, let alone having knowledge in advance of thousands of brains. What we do know, though, is that these competing mechanisms are consistent with the pattern we see in equity returns – for there to be periods of (relative) stability, punctuated by periods of high volatility.
There are two competing mechanisms affecting our attitude to losses. Although there's a disgust effect which leads us to sometimes take risk in the hope of breaking even, Professor Lo points out that there can also be an instinctive "fight or flight" response to danger which can overpower this effect, and cause us to run away, financially speaking. When this happens, we get panics and crashes. Again, we can't tell in advance whether the flight response will or will not overpower the 'get even' response.
What we can say is that there's an evolutionary reason for the flight response. The primitive man who instinctively ran away from danger lived to have children. The one who paused, even momentarily, to assess the risk got killed and did not. We are, therefore, selected to have a fight or flight response. And this might not also help us make good investment decisions.
This isn't the only way in which mankind's distant past affects investment decisions today. It could be that the tendency for shares to fall as the nights get longer is an atavistic echo of the anxiety our ancestors felt when the approach of winter led them to fear for their food supply. Equally, the tendency for shares to rise as spring approaches mirrors the joy that early man felt when he had survived the winter and looked forward to the more plentiful food the summer would bring.
You might think that the lesson here is to discipline ourselves to overcome our emotions and so act rationally.
Not so, says Professor Lo. He points to the case of a man who, after having a brain tumour removed, lost his capacity to feel emotion. Although otherwise healthy and intelligent, he soon became unemployable. Because he had no emotions, he was unable to tell what was important and what was not, and so he would spend hours deliberating over trivial matters such as what to wear or eat while neglecting urgent tasks. Emotions, says Professor Lo, "are central to rationality". They are what make us feel pleasure and pain, and thus respond to incentives.
Instead, there is perhaps a bleaker lesson – that we are just not physiologically adapted to make optimal investment decisions. Professor Lo says: "Evolutionarily advantageous responses by homo sapiens to threats on the plains of the African savannah 50,000 years ago may not be as effective in dealing with threats on the New York Stock Exchange." How true.
