Author: Richard Taffler, FSIP
Emotional finance is an important way to think about investment decision-making and markets, believes Richard Taffler, FSIP.
The new paradigm of emotional finance describes how our emotions, both conscious, and most importantly, unconscious, help drive our investment decisions and the behaviour of markets more generally. It gives investors a practical language to talk and think about this. In contrast to behavioural finance, which focuses on cognitive biases and decision errors, emotional finance directly addresses the underlying needs, fantasies and anxieties of investors. By acknowledging the vital role emotions play in all investment activity, money managers are better able to deal with the intense pressures they have to operate under. As a result, they make better investment decisions.
The Myth of Rationality
Unconscious psychic processes are central in the way we deal with the world. Emotional finance teaches us that the belief that we can ever be, or even learn to be, ‘rational’, is a defence against the inherent uncertainty of financial markets. Emotions of excitement, anxiety, and denial are paramount.
One insight of emotional finance, for example, is that of the ‘phantastic object’. Defined as a mental representation of something (or someone, or an idea) which fulfils an individual's deepest desires to have exactly what they want and exactly when they want it, phantastic objects are particularly powerful as not accessible to conscious reflection. Emotional finance teaches that all investments have the potential to become represented in investor psychic reality as phantastic objects, even in normal day-to-day trading activity, as in the case of the current raft of ‘unicorn’ IPOs.
Unconscious Emotional Relationships
Importantly, emotional finance shows how investors enter into often unconscious emotional relationships with their stocks: they love and hate them, and trust and distrust their managements with such strong emotions often dominating investment fundamentals. Recent empirical research being undertaken at Warwick Business School in fact, shows how a stock’s EQ (emotion quotient) can be measured and is directly priced by the market on top of more conventional stock characteristics, providing the basis for novel investment strategies. Parallel research finds the same dynamic unconscious predictable patterns in markets, particularly in bubble situations. Investors are caught up collusively at times as a group in unconscious wishful thinking.
Fund managers often claim they take all the emotion out of their investment decisions, being detached and rational while other investors panic. However, this is clearly not possible. In fact, neuroscientists describe how we need our emotions to make effective decisions. We should embrace our intuition and feelings, rather than seek to repress them, which in any case only means they come back to bite us in unpredictable ways.
What do clients really want from their fund manager? Emotional finance demonstrates that what they need goes well beyond alpha. Investors are entrusting their financial future to managers, and they look for reassurance and comfort that they are in good hands – to trust is to invest! An emotionally aware fund manager recognises this. The fund manager unconsciously carries investors’ anxieties about the uncertain future on their behalf. Ultimately, the fund manager acts as what psychoanalyst Wilfrid Bion describes as an ‘emotional container’, referring to the earliest stages of infancy, intuitively in touch with investors’ psychological needs and bearing their anxieties for them.
Active Versus Passive
Emotional finance can also contribute to the active versus passive debate. It recognizes that earning superior returns is only part of the fund manager’s role. Actively managed funds allow investors to experience their unconscious need for excitement in terms of the opportunity to outperform with relatively little downside risk. Passive funds, on the other hand, are for investors who only have return needs.
Emotional finance shows us that the ability to trust when not knowing the outcome trumps anxiety, leading to conviction to commit, and this can help explain why many fund managers view the bedrock of their investment process as meeting and assessing company management. However, are such meetings really information seeking, or more for psychological reasons? It is not clear whether the strength of the handshake or body language has any relationship with future stock returns.
Emotional finance likewise is very clear about the need to provide an emotionally supportive environment for the fund manager in their stressful and demanding role. The opportunity to talk freely about his or her feelings is only the very first stage in improving mental health in the industry. The relationship: uncertainty -> anxiety -> stress is a key acknowledgement of emotional finance.
Emotional finance is being increasingly applied across a wide spectrum of investment activities. Nonetheless, it is still in its early stages of development as a new discipline. However, it is already very clear how emotional insight pays large dividends for asset managers.
Richard Taffler, FSIP, is a Professor of Finance at Warwick Business School.