Before we get to finance, consider these two common occurrences:
1. Imagine it is Friday Night. You do not have to work until Monday. In fact you have no commitments. You just finished all of your tests, papers, etc. You are home alone. All of your friends are out. You imagine them having great time "out" frequenting local "watering-holes" or at parties, sporting events, or plays (incidentally whether they really are having a great time is quite irrelevant, that you think they are is what counts here). Even though you went out last weekend and really did not have much fun, you think that this time will be different and you head out.
2. You just have a first date (or your first day on a new job or even the start of a new sports season). You are excited. Things seem to be going well. And you instantly think they will keep going well.
What do these scenarios have to do with finance? Possibly a lot.
Financial Bubbles: Why Do Fools Fall in Love? at SmartMoney.com:
"Paul Zak, founding director of the Center for Neuroeconomics Studies at Claremont Graduate University, points to a number of quirks in our brains that might be responsible. One is that over-stimulation of the “reward” centers of our brains appears to steer us toward more risk. For instance, it’s been shown in laboratory experiments that men in a state of sexual arousal are more likely to make risky financial decisions.Similar arousal has been speculated on as being created by the competition in the market. Missing out on the fun that you think others is having creates a sense of regret that makes you want to participate. Additionally, it is a monkey-see, monkey-do world.
Again from the article:
"Another factor is how our brains experience regret when we see the money we could be making in, say, a rising stock market. In one experiment, subjects were imaged in an MRI machine while playing a stock-market investment game. If a person saw the stock market go up when they didn’t have much money invested in it, the scientists were actually able to see the “regret” signal in the subject’s brain. And the more regret a person felt, the more he or she invested in the market as the game went on. While this kind of “fictive learning” can be useful in other contexts, in asset markets it’s a recipe for disaster."
Monkey see, monkey do?
"Lastly, Zak points to our basic evolutionary nature: “We’re a herd species. When the rest of the herd’s doing something, they’re all running in formation, it really seems like we ought to do that, too.”"