Wednesday, April 30, 2008

Phantastic phinance

It's hardly a secret that the rational agent hypothesis of neoclassical economics is, at best, an idealisation; and, at worst, a dangerous myth. It's much the same for the rational investor of finance theory, as backed up by a host of behavioural studies.

You don't need to have experienced many investment bubbles, crazes and panics to appreciate that. Some diehards have claimed that bubbles can be understood as rational phenomena, but that always seems like stretching the definition a little too far.

It's interesting then to get the psychoanalytic point of view on a question that has been dominated by economists. David Tuckett of UCL and Richard Taffler of Edinburgh Uni have a paper in the new International Journal of Psychoanalysis with the delectable title Phantastic objects and the financial market’s sense of reality: A psychoanalytic contribution to the understanding of stock market instability.

Tuckett lays it out in the UCL press briefing:
“Feelings and unconscious ‘phantasies’ are important; it is not simply a question of being rational when trading. The market is dominated by rational and intelligent professionals, but the most attractive investments involve guesses about an uncertain future and uncertainty creates feelings. When there are exciting new investments whose outcome is unsure, the most professional investors can get caught up in the ‘everybody else is doing it, so should I’ wave which leads first to underestimating, and then after panic and the burst of a bubble, to overestimating the risks of an investment.

“Market investors’ relationships to their assets and shares are akin to love-hate relationships with our partners. Just as in a relationship where the future is unexpected, as the market fluctuates you have to be prepared to suffer uncertainty and anxiety and go through good times and bad times with your shares. You can adopt one of two frames of mind. In one, the depressive, individuals can be aware of their love and hate and gradually learn to trust and bear anxiety. In the other, the paranoid schizoid, the anxiety is not tolerated and has to be detached, so the object of love is idealised while its potential for disappointment is ‘split’ off and made unconscious.

“What happens in a bubble is that investors detach themselves from anxiety and lose touch with being cautious. More or less rationalised wishful thinking then allows them to take on much more risk than they actually realise, something about which they feel ashamed and persecuted, but rarely genuinely guilty, when a bubble bursts. Again, like falling in idealised love, at first you notice only the best qualities of your beloved, but when everything becomes real you become deflated and it is the flaws and problems that persecute you and which you blame.

“Lack of understanding of the vital role of emotion in decision-making, and the typical practices of financial institutions, make it difficult to contain emotional inflation and excessive risk-taking, particularly if it is innovative. Those who join a new and growing venture are rewarded and those who stay out are punished. Institutions and individuals don’t want to miss out and regulators are wary of stifling innovation. If other investors are doing it, clients might say ‘why aren’t you doing it too, because they’re making more money than we are’.”

That last point seems to bring us into the realm of situational psychology. I've recently been reading Phil Zimbardo's The Lucifer Effect on that area - an interesting and disturbing read. Most of the behavioural finance studies I've read (or, at least, read about) concentrate on the personal biases and heuristics that affect individual decisions - the effects of peer pressure and groupthink on economic decision-making seems a fruitful area for further study.

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