Survival of the Richest

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TR: And what you've found is that people can evolve past that instinct?

AL: It's really survival of the richest. The traders that are successful are the ones that survive and make money. The ones that engage in the kind of loss aversion most of us are subject to end up losing their money and they leave the [trading] population.

TR: You've studied actual traders from a couple of perspectives. [Lo has published papers on the psychophysiology of traders, measuring skin conductance, heart rates, and the like, and correlating these measurements to market activity.] Where does the functional magnetic resonance imaging (FMRI) come in to play?

AL: We have a conjecture that there are certain components of the brain that are responsible for trading, and we want to see whether or not we're right.

TR: You literally have people hooked up to an MRI during their trading day?

AL: The test subject is a day trader. He lies in the MRI machine and can see the screen of a laptop computer using a mirror in the MRI machine. His hands are free to use a mouse and he simply pulls up his trading software and we have a mouse that's made of all plastic components -- it costs $5,000 -- and he uses it to monitor the markets while we're imaging him, and makes trades.

TR: What do you gain from knowing what parts of the brain are used in trading?

AL: We know that emotional responses -- things like sweaty palms and increased heart rate -- correlate with fluctuations in the market. MRI provides us with a more refined understanding of how financial decisions get made. Is there specific circuitry in the brain that's designed for financial decision-making versus a combination of existing components that are used for other kinds of decision-making that happen to get borrowed for financial decision-making? From very preliminary evidence, it looks like the answer is that there isn't a financial market decision-making center in the brain.

This is important because I think it supports and confirms the Adaptive Markets Hypothesis. It says that humans are not ideally suited for economic decisions. The same faculties or heuristics for deciding whether or not to cross a busy street are used to decide whether to buy Microsoft or sell General Electric. Those heuristics will fail because they are not optimized for a financial context -- they are optimized for the physical world. So one needs to be a little more cautious about making [financial] decisions using those kinds of heuristics.

TR: What else are you working on now?

AL: I'm also looking at hedge funds, as a kind of laboratory for studying the impact of the evolution of the markets. Hedge funds are the Galapagos Islands of financial markets: the barriers to entry are low, the rewards are very high, and therefore the competition is fierce and species are coming and going all the time.

TR: What kinds of things nag at you about your hypothesis?

AL: The open questions are what are the dynamics that drive evolution? There's always this tension between environmental conditions and the genetic predisposition of the population. I don't have a clear understanding of the notion of genes. I haven't worked out the dynamics of the generational transfer of genetic material in a corporate and financial context.