Posted by: Dirk | October 11, 2011

How unrealistic optimism is maintained in the face of the efficient market hypothesis

OK, I changed the title a bit to link it rational actors on financial markets. Actually, this is the title of the paper (well, almost) published in nature neuroscience, written by Tali Sharot, Christoph Korn and Raymond Dolan. Here is their abstract:

Unrealistic optimism is a pervasive human trait that influences domains ranging from personal relationships to politics and finance. How people maintain unrealistic optimism, despite frequently encountering information that challenges those biased beliefs, is unknown. We examined this question and found a marked asymmetry in belief updating. Participants updated their beliefs more in response to information that was better than expected than to information that was worse. This selectivity was mediated by a relative failure to code for errors that should reduce optimism. Distinct regions of the prefrontal cortex tracked estimation errors when those called for positive update, both in individuals who scored high and low on trait optimism. However, highly optimistic individuals exhibited reduced tracking of estimation errors that called for negative update in right inferior prefrontal gyrus. These findings indicate that optimism is tied to a selective update failure and diminished neural coding of undesirable information regarding the future.

Of course, not all macroeconomics models need to incorporate these findings. However, if you assume that financial markets are always in equilibrium and that this “sloppiness” in portraying reality has no consequences for your conclusions, then you might want to reconsider.

Now I am waiting for the next bail-out of the banking sector, when Goldman’s CEO Lloyd Blankfein will declare in front of Congress: “While the music was playing, we suffered a selective update failure and diminished neural coding of undesirable information regarding the future. We’re sorry.”

It’s called scientific progress.

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