Beware Phantastic Investments

"A good story is more compelling than the search for the truth."
-Shakespeare, Richard III

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 holds conflicting emotions about a person, idea or thing simultaneously... 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 relationships with the world. This means investing involves entering into an emotional and unconscious relationship with the assets you own.

Research team Richard Taffler, a professor of finance and investment and David Tuckett, a professor of psychoanalysis, who 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." These unrecognized emotions are often more powerful than either facts or the results of objective analysis, driving investors towards oscillating 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 decision-making 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 understand investor behavior.

Separating Fact From Fantasy

Formulating judgments about, and acting on, information 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 investor return.

Taffler and Tuckett see the commitment as forming an important relationship with the asset — one that can bring happiness or let you down. They suggest, "When we commit to an investment strategy, we commit to an imagined relationship with consequences — a relationship not unlike a marriage contract." They go 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)."

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 return. This form of relationship makes assets overly attractive while they are performing and then horribly disappointing when their momentum turns. Such a full throttle reversal 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 out-performance. 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, thereby, injecting 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 "... that caused by unavoidable information asymmetries at the moment of decision-making, and that determined by the fact the future is inherently unknowable." 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."

While the manager's unconscious is battling information asymmetry, it is also being harassed by uncertainty about the future. Imagining 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, is often dealt with by splitting the good feelings (upside) from the bad (downside risk) — a defense mechanism that calms emotional stress and bolsters conviction while increasing portfolio volatility. Although rigorous processes can guide imagination toward a well-reasoned judgment, they may provide no protection from the anxiety generated when actually making investment decisions.

You're Phantastic!

Experience and introspection lead managers 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 enables managers 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 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.

Being over excited you act emotionally, often running roughshod over any remnants of reasoned analysis. This behavior relates to what Taffler and Tuckett have termed a "phantastic object". The term phantastic object they explain "... is derived from two ideas. The Freudian concept of object denotes a mental representation, i.e. a symbol of something in our mind but not the actual thing itself. Phantasy is a technical term which psychoanalysts use to describe an individual's unconscious beliefs and wishes which come from the earliest stages of an infant's mental development. Thus a phantastic object is a mental representation of something (or someone, or an idea) which fulfils the individual's deepest desires to have exactly what they want and exactly when they want it." Relating this to investing, the phantastic object is initially seen as possessing superior qualities, well above the usual opportunity, allowing the manager to achieve his emotional goal of delivering exceptional returns with no downside risk — simply phantastic. But because this impression of the asset is created in part by suppressing thoughts and feelings about its limitations or risks (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.

The Emotional Factor

In their book to be published later this year, the research team discusses 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 is 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 future being unpredictable, business risk and career risk. As Professor Taffler explains, "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."

Taffler and Tuckett see conventional risk models as providing pseudo-defenses against uncertainty. They suggest that the practice of performing regressions against historical relationships can abet one in believing they can know more about the future than is possible. This overconfidence about risk aids managers in splitting — enabling them to focus on potential gains since the risks feel like they have already been managed. This view is consistent with Kahneman and Lovallo who found that the act of addressing uncertainty can lead to an illusion of control and under-appreciation of actual risk. In practice, managers are known to override portfolio optimizers in the normal course of business. These decisions to "go against the science" of the risk models are commonly defended as the manager having a strong intuition about an asset: An alternative explanation is reaching for a phantastic object.

Conclusion

Reasoning means telling stories to yourself. The more objective the stories, the more sound each investment thesis. Thesis formulation relies on making judgments about events whose outcomes are inherently uncertain. These judgments produce anxiety that adversely impacts objective decision-making.

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 self-awareness is one way to combat the unconscious forces that drive unintended decisions. You just can't build fantastic performance owning phantastic objects.

References:
1. Taffler, Richard J., Martin Currie Professor of Finance and Investment, University of Edinburgh. Exclusive interview with Cabot Research, December 23, 2009.
2. Taffler, Richard J. and David A. Tuckett. "Emotional Finance: The Role of the Unconscious in Financial Decisions." Chapter 5 in Behavioral Finance (eds. Kent Baker and John Nofsinger), Wiley 2010, forthcoming.
3. Tuckett, David. "Addressing the Psychology of Financial Markets." Economics, The Open-Access, Open Assessment E-Journal, vol. 3, 2009-40.
4. Taffler, Richard J. and David Tuckett. "How a State of Mind Abets Market Instability." The Financial Times, September 21, 2007.
5. Taffler, Richard J. and David Tuckett. "Emotional Finance: Understanding What Drives Investors." Professional Investor, Autumn, 2007, pp. 18-20.
6. Kahneman, Daniel and Dan Lovallo, "Timid Choices and Bold Forecasts: A Cognitive Perspective on Risk Taking", Management Science, vol. 39, no. 1, January 1993, pp. 17-31.

Additional Reading:
1. Tucket, David 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, vol. 89, no. 2, 2008, pp. 389-412.
2. Eshraghi, Arman and Richard Taffler. "Hedge Funds and Unconscious Fantasy." University of Edinburgh Business School Working Paper, November 26, 2009. Available electronically at: http//ssrn.com/abstract=1522486.