Thinking you know what the intentions of other investors are could put you at greater financial risk during bubbles. The assignment of intentionality explains why. Humans have long assigned intention to interpret complex behavior, a concept known as theory of mind.

In the case of bubbles, there is a correlation between theory of mind abilities and increased blood flow to the ventromedial prefrontal cortex (vmPFC) and the dorsomedial prefrontal cortex (dmPFC). The vmPFC encodes value, while the dmPFC is associated with being able to judge how others will act. The authors view this activity as suggesting “participants are taking into account the intention of other players in the market (or of the market as whole) while updating their value estimates, and that this effect is mediated by the interaction between dmPFC and vmPFC.”

Though brain activity does fluctuate during normal, non-bubble market conditions, the brain activity observed in this California Institute of Technology study is specific to bubble markets. The study’s authors say the interaction between dmPFC and vmPFC is a response to real or perceived changes in intentionality.

In a press release, co-author Colin Camerer says the results imply that some investors think more about what is going on the market and why others were behaving the way they were. This thought process is combined with the assumption that the timing of when to buy into and sell out of the bubble can be figured out. They further assume insiders with information are actively engaging in the market and profits can be made as result.

Fellow co-author Peter Bossaerts says this type of behavior is highly risky, however. “It’s group illusion. When participants see the inconsistency in order flow, they think that there are people who know better in the marketplace and they make a game out of it. In reality, however, there is nothing to be gained because nobody knows better.”

Sources: “In the Mind of the Market: Theory of Mind Biases Value Computation during Financial Bubbles,” Benedetto, De Martino, John P. O’Doherty, Debajyoti Ray, Peter Bossaerts, and Colin Camerer, Neuron, September 18, 2013; “Caltech Research Shows Neural Underpinnings of Financially Risky Behavior,” California Institute of Technology, September 18, 2013.