Behavioral Matters:
Insights from the application of Behavioral Finance
Issue 17 – January 6, 2010
Behavioral Matters is a series of essays on the application of Behavioral
Finance written specifically for professional investors and portfolio
managers.
Beware Phantastic Investments
A great deal of intelligence can be invested in ignorance when the
need for illusion is deep.
Saul Bellow, To Jerusalem and Back: A Personal Account
By its very nature, investing requires making estimates about future
events. These estimates reflect the manager’s analysis of facts
combined with imagining likely but unsure outcomes. Imagination is
what enables skilled investors to see opportunities ahead of the crowd.
It can also excite emotions that make it difficult to distinguish real
investment opportunities from “phantastic” ones.
Emotional Investing
The theory of emotional finance examines investor tendencies through
the lens of Freudian psychoanalysis. Sigmund Freud suggested that
thoughts cause people to experience two basic types of feelings,
pleasurable or painful. Pleasurable feelings, understandably, are
sought out, and painful ones are avoided or repressed. According to
Freud, the seeking and avoiding all occurs within the unconscious. In
addition, he proposed that the mind often simultaneously holds
conflicting emotions about a person, idea, or thing … like/dislike,
love/hate, and trust/distrust being common conflicts. Because these
conflicting feelings are both strong and unknown to the conscious
mind, they affect our beliefs about our relationship with the world.
Investing thus involves entering into an emotional and unconscious
relationship with the assets you own.
The research team of Richard Taffler, a professor of finance and
investment, and David Tuckett, a professor of psychoanalysis, who
together developed the theory of emotional finance, extend these
Freudian concepts into investing. According to Professor Taffler,
“People are prone to unrecognized emotions—fears and fantasies—
which Freud described as the main components of unconscious mental
life and the deep drivers of human judgment.” 1 These unrecognized
emotions are often more powerful than either facts or the results of
objective analysis, driving investors to oscillate between feelings of
hope and fear about their investments.
Taffler and Tuckett are quick to acknowledge the vital contributions
that behavioral finance has made to the understanding of decisionmaking under uncertainty. Their concern with the direction of current
behavioral finance inquiry, however, is that it often tends to focus on
the cognitive underpinnings of ineffective judgmental tendencies
alone. They argue that cognition and emotion need to be studied
together to truly explain investor behavior.
Separating Fact from Fantasy
Formulating judgments about information and acting on it before it is
fully priced into the market is how managers add value to investing.
Typically, they identify promising candidates (either purely bottom-up
or supported with systematic screening) and then choose specific
names to own. Ultimately, purchasing an asset requires a
commitment—capital, ongoing attention, and choosing when to
liquidate.
David Tuckett sees the ownership commitment as the formation of an
important emotional relationship with the asset—one that can bring
happiness or let you down. He suggests, “When they commit to an
investment strategy, they commit to an imagined relationship with
consequences for reward and loss which induce feelings such as
2
pleasure and pain—not unlike a marriage contract.” He goes on to say,
“Psychoanalysts postulate three principal kinds of imagined emotional
relationships, governed by L (loving), H (hating), and K or -K (knowing
or anti-knowing).”2
Objective decision-making requires “knowing” the asset—being aware
of its potential to please and disappoint and accepting both as a
balanced reason for owning it—an integrated view. This reflects the
type of unemotional objectivity that is associated with disciplined
investing. It grounds manager decisions so that winners are sold as
their thesis is achieved and losers are reevaluated and then sold or
kept based on their go-forward potential.
Conversely, “anti-knowing” involves splitting potential pain from
pleasure. For buys, this amounts to avoiding the unpleasant feelings
related to the risk of loss while focusing on the potential pleasure from
a gain. This form of relationship makes assets overly attractive while
they are performing and then horribly disappointing when their
momentum turns. Such abrupt and full-throttle reversals between
“loving and hating” causes overbuying and overselling as investors
gather up pleasure and disgorge pain.
Emotional Narratives
Assets commonly are chosen because they represent a strong thesis.
The thesis is a simple narrative description of all the facts known about
the asset plus a judgment of why these facts indicate likely
outperformance. Formulating the thesis involves assessing potential
risks as well as returns. A fundamental aspect of this process requires
managers to contemplate future events whose outcomes are highly
uncertain. Contemplating the unknowable produces anxiety for
managers, who then inject emotional content into their analyses.
These anxieties push buttons within the manager’s unconscious,
having the effect of short-circuiting their otherwise disciplined
approach to decision-making.
There are two types of anxiety produced by investing, according to
Taffler and Tuckett: “One set of uncertainties was caused by
unavoidable information asymmetries as they tried to sort out the
mass of ambiguous information with which they were bombarded at
the moment of decisionmaking. Another set was determined by the
fact that, however well they know the present, the future is inherently
unknowable.”3 Information asymmetry undermines conviction, niggling
away at the manager’s resolve, or as the researchers suggest: “This
judgment creates anxiety. First, there is the fear that the information
they have been given by the firm’s management is untrustworthy,
second there is the fear that even if the information and their
underlying analysis is correct, the rest of the market may never come
to share their view.”4
While the manager’s unconscious is battling information asymmetry, it
is also being harassed by uncertainty about the future. Imagining
3
tomorrow’s outcomes is one thing; betting that they will materialize is
quite another. Together, these two sources of uncertainty create
anxiety that, as mentioned, we often deal with by splitting the good
feelings (the upside) from the bad (the downside)—a defense
mechanism that calms emotional stress and bolsters conviction while
increasing portfolio risk. Although your current processes can guide
imagination toward a potentially unique idea, they may offer no
protection from the anxieties generated throughout the analysis and
ownership of the asset.
You’re Phantastic!
It always pays to be mindful that an asset is a probabilistic mix of risk
and return, with the potential to deliver both pain and pleasure. This
integrated perspective can enable investors to manage a thesis more
effectively— objectively knowing when to hold their conviction and
when to change. When assets are held for reasons rooted more in
emotion than reasoned expectation, the unconscious has more control
over investment decisions. As positions migrate from gain to loss and
back again, these shifts in performance trigger emotions that invoke
thoughts about your relationship with the asset, and these thoughts
foster further emotions, and so on. The cycle repeats until the
unconscious has you cornered—you either love or hate the investment.
When you are overexcited, you tend to act emotionally, often running
roughshod over any remnants of analytic thinking. This behavior
relates to what Taffler and Tuckett have termed a “phantastic object,”
which is derived “from two psychoanalytic concepts. The term object is
used in the same sense as it is in philosophy, as a mental
representation; in other words as a symbol of something but not the
thing in itself. The term phantasy (which gives rise to the term
phantastic), as mentioned in Freud’s (1908) view … refers to an
imaginary scene in which the inventor of the phantasy is a protagonist
in the process of having his or her latent (unconscious) wishes fulfilled
(Laplanche and Pontalis, 1973, p. 314). Thus, a ‘phantastic object’ is a
mental representation of something (or someone) which in an
imagined scene fulfils the protagonist’s deepest desires to have exactly
what she wants exactly when she wants it.”5 Relating this concept to
investing, managers initially see the phantastic object as possessing
superior qualities, well above the usual investment opportunity,
allowing them to achieve their emotional goal of delivering exceptional
returns with no downside risk. In other words, this opportunity is
simply phantastic. But because this impression of the asset is created
in part by suppressing thoughts and feelings about its limitations and
risks—what Tuckett and Taffler describe as “splitting”—its inevitable
disappointment gives credence to the lingering doubts stored in the
unconscious. What once was loved becomes hated and a hold quickly
turns into a sell.
4
The Emotional Factor
In their monograph Fund Management: An Emotional Finance
Perspective (CFA Institute, 2012), the research team discussed
findings from in-depth interviews conducted by Professor Tuckett with
over 50 fund managers from around the globe. One of the many
insights from these interviews was the nature of risk, specifically risk
felt by managers. When talking about their greatest exposures, this
group of managers tended to discuss information risk, the
unpredictable nature of the future, business risk, and career risk.
Professor Taffler explained, “These are very different to conventional
measures of risk. Yet these are the real risks managers worry about.
So the concept of risk also has a key emotional dimension.”6
Taffler and Tuckett see conventional risk models as providing
pseudodefenses against uncertainty. They suggest that the practice of
performing regressions against historical relationships can lull
individuals into believing that they know more about the future than is
possible. This overoptimism about the future or, conversely,
overconfidence about the ability to control uncertainty facilitates
managers in splitting—enabling them to focus on potential gains, since
they feel as if they have already managed the risks. This interpretation
of unconscious processing is consistent with Kahneman and Lovallo’s
finding that the mere investigation of uncertainty can lead to an
illusion of control and underappreciation of actual risk. 7 One likely
example of this behavior is when managers override portfolio
optimizers to retain or pump up the size of favorite positions. These
decisions to “go against the science” of the risk models are commonly
defended as the manager’s having a strong intuition about an asset:
An alternative explanation is that she is reaching for a phantastic
object.
Conclusion
Reasoning involves telling stories to yourself. The more objective the
stories there are, the more sound is each thesis and investment
decision. Thesis formulation relies on making judgments about events
whose outcomes are inherently uncertain. These judgments produce
anxiety that often has an adverse impact on the assessment of risks as
assets are being evaluated.
The new theory of emotional finance examines how the unconscious
management of anxiety affects investment decisions. It offers
additional insights into how unconscious motivations easily erupt into
buy and sell decisions. The brain is terribly adept at substituting
emotions for facts in order to make a financial decision that feels right.
This unconscious means of decision-making represents a constant
counterforce to your intended discipline and process. Heightened selfawareness is one way to combat the unconscious forces that drive
unintended decisions. You just can’t build fantastic performance by
owning phantastic objects.
5
Notes
1. Richard J. Taffler, Martin Currie Professor of Finance and
Investment, University of Edinburgh, exclusive interview with Cabot
Research LLC, December 23, 2009.
2. David Tuckett, “Addressing the Psychology of Financial Markets,”
Economics: The Open-Access, Open Assessment E-Journal 3, no. 40
(2009), 5.
3. David Tuckett and Richard Taffler, “Phantastic Objects and the
Financial Market’s Sense of Reality: A Psychoanalytic Contribution to
the Understanding of Stock Market Instability,” International Journal of
Psychoanalysis 89, no. 2 (2008): 407.
4. Richard J. Taffler and David Tuckett, “Emotional Finance:
Understanding What Drives Investors,” Professional Investor (Autumn
2007), 18–20.
5. Tuckett and Taffler, “Phantastic Objects and the Financial Market’s
Sense of Reality,” 395.
6. Taffler, interview with Cabot Research, December 23, 2009.
7. Daniel Kahneman and Dan Lovallo, “Timid Choices and Bold
Forecasts: A Cognitive Perspective on Risk Taking,” Management
Science 39, no. 1 (January 1993), 17–31.
Further Reading
Arman Eshraghi and Richard Taffler, “Hedge Funds and Unconscious
Fantasy,” University of Edinburgh Business School Working Paper,
November 26, 2009, http:// ssrn.com/abstract=1522486.Nature,
January 22, 2004.
Richard J. Taffler and David Tuckett, “How a State of Mind Abets
Market Instability,” Financial Times, September 21, 2007.
6