This Is Your Brain on Prosperity: Andrew Lo on Fear, Greed, and Crisis Management


Andrew W. Lo
is the Harris & Harris Group Professor at M.I.T. and director of its Laboratory for Financial Engineering. (Here are some of his papers.)

To my mind, he’s one of the most fluent guides to the state of modern finance in that he combines the rigors of a quant with a behavioralist’s appreciation for human intricacy. He has agreed to write a guest post here (hopefully not his last — please encourage him!), an insightful look at how “extended periods of prosperity act as an anesthetic in the human brain,” lulling everyone involved into “a drug-induced stupor that causes us to take risks that we know we should avoid.”

Fear, Greed, and Crisis Management: A Neuroscientific Perspective
By Andrew W. Lo
A Guest Post

The alleged fraud perpetrated by Bernard Madoff is a timely and powerful microcosm of the current economic crisis, and it underscores the origin of all financial bubbles and busts: fear and greed.

Using techniques such as magnetic resonance imaging, neuroscientists have documented the fact that monetary gain stimulates the same reward circuitry as cocaine — in both cases, dopamine is released into the nucleus accumbens. Similarly, the threat of financial loss activates the same fight-or-flight circuitry as physical attacks, releasing adrenaline and cortisol into the bloodstream, which results in elevated heart rate, blood pressure, and alertness.

These reactions are hardwired into human physiology, and while some of us are able to overcome our biology through education, experience, or genetic good luck, the vast majority of the human population is driven by these “animal spirits” that John Maynard Keynes identified over 70 years ago.

From this neuroscientific perspective, it is not surprising that there have been 17 banking-related national crises around the globe since 1974, the majority of which were preceded by periods of rising real-estate and stock prices, large capital inflows, and financial liberalization. Extended periods of prosperity act as an anesthetic in the human brain, lulling investors, business leaders, and policymakers into a state of complacency, a drug-induced stupor that causes us to take risks that we know we should avoid.

In the case of Madoff, seasoned investors were apparently sucked into the alleged fraud despite their better judgment because they found his returns too tempting to pass up. In the case of subprime mortgages, homeowners who knew they could not afford certain homes proceeded nonetheless, because the prospects of living large and benefiting from home-price appreciation were too tempting to pass up. And investors in mortgage-backed securities, who knew that the AAA ratings were too optimistic given the riskiness of the underlying collateral, purchased these securities anyway because they found the promised yields and past returns too tempting to pass up.

If we add to these temptations a period of financial gain that anesthetizes the general population — including C.E.O.’s, chief risk officers, investors, and regulators — it is easy to see how tulip bulbs, internet stocks, gold, real estate, and fraudulent hedge funds could develop into bubbles. Such gains are unsustainable, and once the losses start mounting, our fear circuitry kicks in and panic ensues, a flight-to-safety leading to a market crash. This is where we are today.

Like hurricanes, financial crises are a force of nature that cannot be legislated away, but we can greatly reduce the damage they do with proper preparation.

Because the most potent form of fear is fear of the unknown, the most effective way to combat the current crisis is with transparency and education. In the short run, one way to achieve transparency is for our president-elect to convene a “crisis summit” once in office, in which all the major stakeholders involved in this crisis, and their most knowledgeable subordinates, are invited to an undisclosed location for an intensive week-long conference.

During this meeting, detailed information about exposures to “toxic assets,” concentrations of risky counterparty relationships, and other systemic weaknesses will be provided on a confidential basis to regulators and policymakers, and various courses of action can be proposed and debated in real time. Afterward, a redacted summary of this meeting should be provided to the public by the president, along with a specific plan for addressing the major issues identified during the conference. This process would go a long way toward calming the public’s fears and restoring the trust and confidence that are essential to normal economic activity.

In the long run, more transparency into the “shadow banking” system; more education for investors, policymakers, and business leaders; and more behaviorally oriented regulation will allow us to weather any type of financial crisis. Regulation enables us to restrain our behavior during periods when we know we will misbehave; it is most useful during periods of collective fear or greed and should be designed accordingly. Corporate governance should also be revisited from this perspective; if we truly value naysayers during periods of corporate excess, then we should institute management changes to protect and reward their independence.

If “crisis is a terrible thing to waste,” as some have argued, then we have a short window of opportunity — before economic recovery begins to weaken our resolve — to reform our regulatory infrastructure for the better. The fact that time heals all wounds may be good for our mental health, but it may not help maintain our economic wealth.

Jerry Brown

Andrew et al:
With everyone from Allen Greenspan to my best frend the CPA addmitting that the stockmarket is a fuction of perception rather than fact, and your sited study of human response why is there not a louder call for regulation?Why is there not a recognition that Type A personalities are responsable for most of the misery self inflicted on the human condition. With all of the sports huligans to dare devils and high wire act finacial gurus, it is still a minority of the population. Why are we not more drawn to stable and intelectual leaders and examplars of good behavior ? Have we failed to evolved or is this Devolution?

Jesse B-H

Spot on. I look forward to reading future guest posts. Thank you.


"and more behaviorally oriented regulation will allow us to weather any type of financial crisis"...

And what exactly is that regulation? - Can you have a regulation that says something in the lines of "if asset xxx appreciates by 20% in 12-month period accompanied by xx inflation etc. we call it a bubble and bring down the clamp"? Who likes party-poopers?

I don't think we can fix this. I think we can rely on corporate/human Darwinism to fix this - people/corps with good judgment will prevail. But I agree that education will certainly help.


Hmmm...very interesting. So do these hardwired-into-the- human-physiology reactions further explain the differences between Republicans and Democrats over the issue of economic regulatory policies? Democrats understand that humans are subject to fear and greed during financial bubbles and busts and thus want governmental controls over our "animal spirits" to protect us from ourselves while Republicans are so anesthetized during the financial bubbles that they are blind to the needs of the common man and do not want any governmental regulations to spoil their highs?


Can you explain the rationale for the rating firms re-rating mortgage-based bonds that were below investment grade by re-combining them?

My understanding is that huge amounts of BBB (or worse) bonds were combined into groups that had certain covenants about repayment with the result that they all were re-rated as AAA. AAA has always meant to me that there was substantially no possibility of not being repaid; for example, bonds of the U. S. Government. Obviously that did not turn out to be the case with these bonds. Did the rating companies effectively change this definition of AAA without telling anyone? Or was there some other reason for re-rating these bonds, like having them "insured" by credit default swaps?

Or was there some kind of "model" the rating companies had started to use (without notifying anyone) that assumed certain probabilities, perhaps of repayment or of increasing real estate values? What were their assumptions that obviously turned out to be wrong?

Why has no one blamed the rating companies for these losses? Has anyone sued them?

It seems the present recession is at least partly caused by a lack of trust in which banks are refusing to make loans to even good risks. I can't really blame them since personally, I know I have no confidence in anything a rating company tells me. Nor have I confidence in the due diligence investment managers have claimed to perform. To take a particularly egregious example, there are "feeder funds" that collected, say, a billion dollars that they turned around and put into Madoff's funds. Their only expense was a clerk to occasionally receive and write checks. They charged, say, 1% of a billion dollars, or ten million dollars yearly, yet they couldn't be bothered to spend a few hours to drive upstate to visit Madoff's one-man "auditor" who certified the figures. Any comments on the breathtaking inefficiency of such a method of investing? Any suggestions for improving it?



Not much we haven't already heard except for the week long conference that obviously would be paid(once again) by taxpayer dollars as it would be the gov't doing the "inviting". To me, it;s just another draw on insufficient monies already beaten down due to incompetant, knee-jerk, gov't economic survival "ideas".

Also, there is something in Dr. Lo's article that makes me think he is at least naive about human behavior. His article has all the flavor of an overly optimistic man who thinks human beings are all good hearted souls tainted only by what happens to them in the system. I beg to differ, as many are wrong hearted, if not wrong souled, and constantly look to profit off the financial miseries of others and thus initiate, exaggerate and extend any effects of a general economic breakdown such as we now have. 6000 years of human economic history should have taught him that more effectively, or he is not inclined to learn it.


H, New York, NY

Most interesting revelation - long term exposure to Greed, just as long term exposure to the effects of Cocaine, can be addictive.

The idea of being richly rewarded in the short term (consequences be dammed) is what has driven the country's economy into its current state.

Corporation emphasized short term profits and financial presses heaped praises on those who did, providing free advertising for the drug called "Greed", rarely challenging the dangers that lie ahead.

If only we can find a way to outlaw greed as we've outlawed illicit drugs, there might be a brighter future for all.

Time for Congress to introduce a comprehensive set of usury laws against all forms of greed - excessive excutive pay, bonuses, golden parachutes, predatory lending practices, etc.


How is this confidential meeting any different than the confidential meeting of Cheney held to formulate energy policy?

I prefer the light of day. You don't have a secret conference with the mob to talk about how to combat racketeering in the future.


I find myself pretty much agreeing with the comment above from Ben: the neuroscience part of the argument here is not exactly doing a lot of work.

Really, if you wanted to support the idea that, when we experience prosperity, we are made too complacent about the risks of investment, what is the more compelling piece of evidence, the neurological explanation above, or the direct observation of people's behavior? I should think that the latter represents far firmer evidence. Perhaps adding the neurological explanation on top of the behavioral observation adds a mite bit of further evidence, but even about that I wonder. Personally, if anything I would take the confirmation mainly to go in the other direction: if the neurological phenomena seems to be consistent with the behavioral observation of complacency, then that adds some credibility, if quite limited, to the idea that the neurological techniques are actually measuring complacency.

But let's not let the tail of hypothesis wag the dog of fact here, shall we?



Many know something about the financial markets, but knowing something does not translate into expertise - it is these amateurs people who can logically become "irrationally exuberant". Shouldn't we be able to expect the experts to see things for what they really are, to ascertain the risks, instead of being caught up in the same euphoria? If so, greed is seperate and distinct. If not, what exactly does an expert bring to the table - or are there actually way fewer financial experts than we might have perceived?


While almost all of us depend on the marketplace to survive, there are a few folks who live completely self-sufficiently - the back to the land, off-the-grid sorts. Of course, most people will not or cannot live that way. But it is possible to circumvent modern commerce and meet basic needs.

On a macro level, would it be possible for the US, without being isolationist, to use some of the same principals to insulate our economy from global trends?

For example, could we as a country produce enough raw materials, do enough manufacturing, provide sufficient consumer goods and domestic power to run our country like a a self-sufficient household, "off the grid," if necessary?

It seems like financial markets are by definition volatile. So rather than gambling the basic needs and security of our citizens (homes, jobs, etc.) on its mechanisms, shouldn't we treat it more as a casino, a place where we only invest what we can bear to lose?



I agree with your commentary. It is insightful of human behavior. I hope that common sense does prevail, but I worry too that the resolve to really fix things will dissipate.

Brian Hejka

This article reminds me of Naomi Kline's "Shock Doctrine", taking advantage of the fearful situation, except for "collective good".

And what about at least a bit of moral and principle oriented regulation? Dont you recognise that in the US, despite or because so much (simplist and fundamentalist as their are) talking about God, you are more behaviour-oriented, result-oriented and profit-at-any-cost oriented than all the other countries taken together?

Isn't greed (and fear!), at a psychological level, the contrary of respect, empathy and solidarity?


Oh, this is a face of American academe. And the reason that this face is so happy ... is ... Let me guess... personal wealth... yeah.
The problem is systemic, professor. Go and look up the word.

Larry Baca

Prof. Lo makes an excellent, scientifically-grounded case for why fear and greed hold sway over economic trends. His proposed remedy of a summit is good too. But his most important point, underemphasized in this otherwise excellent post (please keep the coming!) is the importance of *education*.

The financial market "leaders" who would attend Professor Lo's summit are doubtless all well-educated; but what of the general populace who work for these so-called leaders, who voted for them, and who -- let's put it charitably -- were assured by same that government wasn't the solution to the problem, it *was* the problem. Maybe if our educational system required a basic competency in the principles of human behavior, business management, finance and economics -- akin to claimed requirements for math, science, history, civics and the like -- our country would become more resilient to all manner of extremes.

The world is more complex than ever, and yet what passes for education, especially at pre-collegiate levels these days -- is appalling. Invest in a well-educated populace that recognizes its own human limitations and crazy thinking, and I'd bet a lot of society's ills would diminish.


Laura Ghita

All the human impulses - the humanity of each of us - relegated to the neurological experiments - how many have been hooked up to the scanner to make the research relevant? What of the odd ones that do not fit into the statistical relevant data?
20th century totalitarian leaders would be pleased - the proposed "behaviorally oriented regulation" is a scientific interpretation of what utopian nightmares are made of - quashing the idea that people are unique and their behavior - odd, unexpected and even dangerous - is something that is entirely human and necessary for a free society. That each of us would be contained, finally, for the good of "society" by controlling our behavior through laws based in neuroscience? I wonder how the regulations would look like. What are the punishments for those who do not respect the regulations – neurologic examinations to see what are the circuits in the brain that run haywire and do not respond to the regulation? Punishment – mental institutions?
Also, I find interesting the "crisis summit" idea - the president-elect achieving transparency by inviting stakeholders in this crisis to an undisclosed location - and then, after discussions - the "leader" emerging with a solution? order? "behaviorally oriented" master plan?
Between the legislation that would address the brain waves and the president seen as the leader who saves the people from themselves America slides towards the society without crises of which people who want to be free must be afraid from.



What an analysis! It leaves you breathless...

Sometimes the obvious right before our eyes needs the bright light of a genius from MIT to make it oh so clear!

Of course, the way to achieve the so very important transparency required in a democracy is to have a meeting of major stakeholders in the financial fiefdoms, policy makers, regulators and others of the ruling elite (at an undisclosed secret location) to brief them (on a confidential basis, of course) on the systemic weaknesses of our system (and how they should be corrected for the benefit of all attending).

And of course, to give the very important impression of transparency, a (heavily and selectively) redacted summary of the meeting would be provided to the public.

After this annual meeting of the politburo, of course, there will be the required photo session of the comrades embracing the farmers brought in for this august occasion.



"...some of us are able to overcome our biology through education, experience, or genetic good luck, the vast majority of the human population is driven by these “animal spirits”...

Prof. Lo - Gee, feeling a little cocky are we? Do you really believe that anyone can *always* overcome those "animal spirits"?

My almost 60 years on this planet suggest otherwise. No matter how strong our defenses, if we act, we all fall to temptation now and then.

Warren Grimsley

While I agree with Lo's behavioral description of the investor's emotional reactions, I'm not sure that I would agree with his contradictory remedy for our current malady. Should we really seek transparency through secrecy? How is offering the "major stakeholders" the benefit of confidentiality a fair "price" for the information that the public will receive later. Will Lo also accept that the "major stakeholders" should be constrained, e.g., locked up, until the public is allowed to act on the information?
Why rely on a top down approach through secrecy and policy initiatives. The treasury has already thrown a "tarp" over the financial system because the public saw that the bankers were not wearing clothes. Why not a bottom up public market approach where the assets, toxic and otherwise can be appreciated by everyone.
Should we exclude the analysis of shame and disgust in our current situation. These too have important limbic system responses and to hide them from the public or to exclude the public from feeling these emotions themselves is hardly transparent.