Scientists at Emory University got MBA students to forecast companies' earnings and then used fMRI scanners to study their brains' responses to earnings announcements. They found that nice surprises were associated with greater dopamine activity in the ventral striatum while disappointments were associated with less. This is consistent with investors regarding good earnings news as a reward and bad news as a punishment.
But here's the thing. Share price moves were more closely correlated with brain activity than they were with the size of the earnings' surprise. If two companies beat expectations by the same amount, the one that triggers the more dopamine release will see the larger immediate share price move.
And some earnings surprises don't produce much favourable brain response. If investors regard the good news as too noisy to be relied upon, or if they stick to their Bayesian prior that the company is a bad one, there will be no great dopamine release. In these cases, share prices will underreact to good news, which means they could drift upwards later.
The researchers found something else - that brain activity was twice as great in response to bad earnings news as to good. This corroborates a prediction of prospect theory, that a loss hurts more than a gain of the same monetary size. This helps explain why bad earnings news is often taken so badly by the market, and why companies try hard to avoid such news.
Neuroscience therefore seems to confirm the message of behavioural finance - that what matters for share prices is not so much what companies actually do as how our brains respond. And these responses are not entirely consistent with efficient market theory.
