The 2008 financial crisis showed that human emotion has a critical impact on financial markets. The newly established discipline of ’emotional finance’, pioneered by David Tuckett, draws on principles of psychoanalysis to enable financial markets to be understood in a completely new way.
Based on some of the ideas from his groundbreaking new book “Minding the Markets: An Emotional Finance View of Financial Instability” (Palgrave Macmillan), Professor Tuckett provides fresh insights into what happens in the emotionally-charged real world of financial trading.
Conventional thinking about financial markets begins with the idea that security prices always accurately reflect all available information; it ends with the belief that price changes come about only when there is new information. Markets are supposed to reflect new information quickly and efficiently, albeit with a few anomalies.
In 2007, I interviewed over 50 investment managers mainly in New York, Boston, London, and Edinburgh. Talking to them I came to the conclusion that conventional theories of finance miss the essence of market dynamics. Information is usually ambiguous and its value uncertain. When information is ambiguous and outcomes are fundamentally uncertain, decisions are not clear cut. They necessarily rely on human imagination and judgment, not simply calculation. Human imagination and judgment are impossible without human emotion. Conventional theories of finance, which ignore emotion, are therefore a very poor basis for understanding and policy.
Uncertainty and ambiguity are what make financial markets interesting and possible. They generate feelings that manifest in exciting stories, problematic mental states and strange group processes. As long as we neglect emotion’s role in financial markets, and fail to understand and adapt to dimensions of human social and mental life that influence judgement, financial markets will be inherently unstable. They will also be likely to create poor outcomes for ordinary savers and significant distortions in capital allocation – exactly what we have been witnessing in the market today.
Uncertainty and the nature of financial assets
The uncertainty to which I refer can be termed radical, fundamental, Knightian or Keynesian uncertainty. I use these descriptions to stress the fact that, although we can imagine the future, we cannot know it in advance. My interviewees collectively risked over $500 billion every day. Every one of the positions they took depended on interpreting ambiguous information and each would be vulnerable to unforeseen events. Consider the present possibilities that the Euro crisis will lead to a return to national currencies, and that disputes in the US congress will lead to problems meeting US debt obligations. What the existence of such possibilities will do to the prices of commodities, currencies and securities over the next thirty-six months, and what different financial decision-makers will think about it, is not knowable – and there will be many more unexpected developments with significant ramifications.
Decisions made in a radically uncertain context are totally different in their implications from decisions made in conditions of risk modelled as a Gaussian probability distribution. A Gaussian model constrains future probabilities, thereby creating known unknowns. The outcome of decisions becomes predictable and what is rational becomes clear. Under radical uncertainty this is not the case. What will happen tomorrow involves far more complexity and interaction than can be captured by analogies to games of chance. Taking radical uncertainty seriously, therefore, changes everything.
The professional investors to whom I talked were all intelligent, thoughtful, experienced, well-educated and resourceful. Their problem fulfilling their task was not to be rational but how to be so; they used all rational means as far as they could. Rather, their task was to find a way to convince themselves and others their judgments were appropriate and so to gain the support to act. They were paid to act and to stick to their decisions – to buy, hold or sell financial assets – and, in so doing, to outperform their peers and various benchmarks. As my respondents told me about the decisions they had taken in the months before I spoke with them, three rather well known, but nonetheless crucial characteristics of their situations emerged. Each of the three is a consequence of radical uncertainty.
First, because asset prices are volatile, trading financial assets was always about managing the feelings created by volatility. The prices of the financial assets they wanted to trade went up and down all the time. The possibility they would go up was what made financial assets interesting. So they offered opportunity and danger. Crucially, when prices went up they created excitement about imagined reward1. And when they went down they created anxiety about loss and other consequences. In other words, financial assets engage powerful human emotions and go on doing so over time. Owning a financial asset is an emotional experience lived through time.
Second, all financial assets are abstract. They are not concrete items like televisions that can be used, but are symbols that have no use in and for themselves. They are worth only what other people think they are worth and (like shares in some banks, energy companies, and financial institutions or like some government bonds or collaterised debt obligations) this could quite easily be nothing. This is where uncertainty, information ambiguity and perceived trustworthiness are all crucial. The present value of a financial asset is entirely dependent on the future we can imagine and its expected influence on the underlying prospects. What price we will actually see in the future is inherently uncertain. It is dependent not only on the income uncertainly generated by the underlying “fundamental”, but also on the expected demand for the securities from other traders.
Third, success trading financial assets is difficult to evaluate. As a result, feedback on investment performance is fuzzy. Uncertainty and ambiguity mean that what looked like good decisions can turn out to be bad ones and what looked bad can be revealed in time to be great. To evaluate performance, it is easy enough to see if one has gained or lost in any period. But did that reflect skill and what does it “tell”? A buy initiated today can take weeks, months or years to play out. In the meantime, all kinds of other things have changed and the manager is involved in creating new positions and managing others in the portfolio. Traditional measures used in the industry such as return, relative return, attribution and even “hit-rates” provide weak insight into skill or decision quality. They can offer the illusion of understanding while facilitating the neglect of uncertainty.
The 24-hour, 7-days-a-week deluge of information in global financial markets produces inherent ambiguity and can constantly generate excitement or doubt. Even if information is trustworthy, its usefulness for calculating future prices in an uncertain world is dubious. The problem using it is not to behave rationally, but to know how to gain conviction about particular conclusions and then to make a decision to manage the anxiety that one may be wrong.
The way people in a financial market succeed in making decisions in the situation I have just been outlining is obvious – at least once it is stated. To create and support their conviction that their judgements are right, they use the human evolved capacity of telling stories – to themselves and to others.
My respondents told me over 200 stories about their decisions to buy, hold or sell assets. What the “buy” stories did was to organize and make coherent the always ambiguous and incomplete information they had to hand. These stories created scenarios that made sense of what the traders knew and the judgements they were deploying. These stories combined exciting grounds for taking action with secure grounds for trust.
Narrative is one of the important devices humans use to give meaning to life’s activities, to sense truth and to create the commitment to act. Although its procedural logic is different to that in logico-deductive reasoning, reflection will demonstrate that it is not necessarily inferior. This is particularly true in contexts in which data are incomplete and out comes are uncertain. Stories draw on humans’ powerful
capacities for pattern recognition, which allow authors to weave facts, reasons and feelings together to create conviction and a sense of truth. Stories dominate the way we make everyday sense of the world, ordering the relation between things in space and time. Mostly, they succeed in ordering things in a convincing way. But because they function to paper over the doubts created by radical uncertainty they are always a potentially unreliable basis for financial models.
A story does not need to be lengthy or complex. “Greece has a history of fiscal mis-management. It is in the process of defaulting and will take the European financial system with it. Therefore, what I need to do is…” Here the past and future are combined with ideas to produce coherence and support for action. Such narratives, which are widely reported in the financial community, allow investment managers to organise a mass of information about the present and about potential futures.
The process of narrative formation blends human emotions and is unconsciously constructed. Moreover, it is so natural and so aligned with efficient social, psychological and neurobiological functioning that people are often hardly aware this is what they are doing. Narratives are seamlessly developed, socially constructed, and shared as acceptable in financial networks and institutional groups.
Markets in stories
To readers not familiar with orthodox financial theory and to those with experience of real financial markets, all this might sound blindingly obvious. However, orthodox financial theory (including Modern Portfolio Theory, the Capital Asset Pricing Model and the Efficient Market Hypothesis) is a long distance from the reality I just described. This is not trivial. Financial policies and the operation of risk management in financial firms, ratings agencies and regulators have been heavily influenced by these orthodox approaches to finance. The result is that our financial institutional arrangements are built on deeply unreliable models.
Applied to financial markets, the narrative perspective allows us to see things hitherto obscured by more conventional approaches. For instance, it highlights the fact that financial markets are in large part about a portfolio of competing narratives concerning the present and the future.2 Thus, it is important to understand how narrative works and can be influenced. Dominant narratives can create bubbles – like the Dotcom Bubble or the South Sea Bubble. They also create conventional wisdoms (such as those about shareholder value, securitisation, leverage and debt) that have recently had such powerful effects.
Above all, understanding narrative gives us tools with which to understand market dynamics. The dominant narratives in the market – these are similar to what is often meant by “market sentiment” – change through time. New narratives emerge and old ones disappear. To visualise this process of emergence, we can think of a large inflatable ball released in to a crowd at a concert.3 The ball will move around unpredictably: over time, everybody will influence the direction of the ball but no one individual or group will have full control over its movement. The direction the ball is travelling is emergent and inherently impossible to predict. By contrast, the building blocks of orthodox economics and finance are deterministic, which means that with enough information, the direction of the ball ought to be fully determinable. That, however, is not true in reality: like the suppressed equation of risk with uncertainty, determinism is a fundamental flaw in conventional thinking in both finance and economics.
The account of markets as narratives that I have offered does at least make sense to money managers themselves.4 It is also the starting point of the approach to understanding markets which Richard Taffler and I call Emotional Finance. By drawing on some core concepts derived from modern psychoanalysis, this approach focuses on the forces that influence how narratives are developed and spread within financial networks. It explains how money managers and the financial market more generally can collectively tell themselves stories that are ultimately implausible and so create highly consequential, unstable situations.
Emotional Finance proposes that when investors buy, sell or hold all classes of financial assets, they necessarily establish on-going and unconscious mental relationships with them. These relationships are of precisely the same kind as we all form throughout our lives with people and activities. We know that such relationships are based on bodily experience and feeling – emotion – mapped within our complex brains onto narrative representations from memory. In their simplest form, such mental relationships – unconscious phantasies giving meaning to everyday experience – are stories told in the mind. They are representations of the imagined emotional relationship between subject and object which produce good and bad feelings – for example, those associated with the thoughts “I love him”, “he likes me”, “I hate her”, “they make me anxious”.
In discussion with Taffler, I coined the term phantastic object to highlight the object being sought in most financial narratives. The term conjoins phantasy (as in unconscious phantasy) and object (as in the object of a mental representation). It seeks to specify that what is depicted as so attractive and sought after in various financial-market narratives is much more than just the chance to get rich. Stories about phantastic objects detail participation in an imagined mental relationship in which the possessor of the desired object imagines having permanent and exclusive access to it and all good things. This is a phantasy normally if only partially and painfully given up with weaning and later maturation. Tom Wolfe describes it in Bonfire of the Vanities and Michael Lewis in Liar’s Poker.
My respondents were looking for high yield and low risk, which other investors had not spotted. They had to perform exceptionally and to do so had to seek such opportunities – phantastic objects. In effect, they had to live up to the images they projected to the clients who employed them. The narratives supporting the securities they sought out gave them grounds for thinking decisions were exceptionally rewarding and especially safe. This is in fact often the underlying message in asset management advertising. When the Board of Directors at RBS believed it desirable to stuff their balance sheet with mortgage backed securities – magical if incomprehensible products apparently offering security as good as treasuries, but with much higher return – they must have been accepting just such a message. Phantastic objects are strange attractors with the power to disturb thought.
Problematic mental states
Most mental relations and especially those featuring any kind of dependence (on a person or situation or object) are what psychoanalysts call ambivalent: they stimulate contradictory feelings and so contradictory mental representations of the objects. They create potential emotional conflict. “I want to be with him and I want him to go away”; “it will create gain; no, it will cause loss”; “I want to be part of that group and to be away from it” – these are all expressions of such ambivalence. This is easy to apply to securities and indeed to the choice of money manager or pension plan. The crucial point is that we can work to be aware of the contradictions in our relations to objects; we do not have to neglect them. Sometimes emotional conflicts are so powerful that they are unpleasant. We therefore push them from our mind. As a result, they become unconscious, meaning we don’t know we have them.
Good as well as bad human decisions are made in states of mind governed by feelings. In the state of mind I call a divided state, conflicting representations of relationships to an object of the kind just discussed are present in the mind but not consciously known and experienced. They are therefore not available to conscious evaluation. In such states, the relationship to an object may at one moment be consciously felt as only loving and the next as only hating. One moment it means only loss, the next only gain.
The theoretical potential of the concept of a divided state (particularly when pursued in groups subject to what I call groupfeel) is that it helps to explain how people can pursue phantastic objects without setting off alarm bells. In ordinary markets, such objects are pursued in small ways. Sometimes, however, these objects capture the market. Participants then believe that the impossible is really possible. In a divided state, a relationship to a phantastic object (such as the dotcom stocks or once highly desired Greek bonds) moves unpredictably from all loving – i.e. wanting – to all hating, and vice versa. Such movements are observed in personal and work relations and in the relations professional investors have with assets in financial markets.
Divided states contrast with integrated states. The latter involve more nuanced and subtle relationships to objects. In these relationships, the contradictory or conflicting feelings that are stimulated can be simultaneously known. They can therefore be explored and reflected on. Integrated state relationships are more realistic, but they are also more emotionally challenging. Divided states are adopted, of course, precisely because awareness of emotional conflicts can be intolerably frightening or frustrating – as when awareness of conflict would create guilt or shame or the anxiety which might prevent someone like Fred Goodwin doing what he wants.
It is hard to exaggerate the significance of an emotional finance way of thinking for how we understand the financial system. Markets managing uncertainty through exchanging narratives are very different from the markets envisaged by conventional theories. If, for example, the price of securities is in fact governed by narratives shared in groups, the pricing of derivatives based on them cannot possibly make sense using the Black Scholes formulae or similar. Liquidity will dry up very easily, as it has several times recently, precisely due to narratives about banks. Risk modelling too would have to change. Concepts like VaR are inappropriate in a world ruled by narrative and radical uncertainty. Stress-testing needs to look at narratives. The ideas and conventions that have been influencing risk-assessment in financial institutions rest on traditional financial analysis. From my perspective they are misleading and provide false comfort.
A great deal more needs to be done to understand how financial narratives get created and diffused, and what can be done to create counter-narratives to reduce divided states. The framework offered above is intended as a building-block for developing understanding. With it we can see more clearly why the financial system is a great deal more volatile than orthodox financial theory would have us believe – and that it is inherently volatile. This should concern us and spur much more research. By contrast, a lot of the analysis about the financial crisis has looked for causal factors of the financial crisis that are external to the financial system.
For about five years now we have been in the midst of a chronic financial crisis. More acute phases threaten. Some of the solutions to the crisis may reproduce some of the conditions that helped to cause it.
Markets have been nervous and particularly volatile for some years. There is a sense that many losses remain unacknowledged. It seems possible that participants also sense that the problems created by the catastrophic reforms of the 1980’s (based in part on what I consider misleading theories) led markets to become progressively captured by the belief phantastic objects and (and so fantastic performance) were attainable. A divided state became normal. The Euro, for one, has some characteristics of a phantastic object. If this is the case, markets still need to work much harder towards the painful acceptance of reality – an integrated realistic state. For this to be possible requires absolute clarity about where losses lie and a much more serious effort than we have seen to face up to how all this happened and to its implications.
My argument is that financial crises are not due to malignant outside influence but are caused by the power of financial assets in the form of phantastic objects to distort the human mind. It is in the interests of nearly everyone to contain this situation. We must begin by understanding this distortion and its influence throughout the financial network. Neither conventional economics nor even modern behavioural economics focusing on bias are at all helpful for such a task.
About the author
David Tuckett is Professor of Psychoanalysis and Director of the Emotional Finance Project at UCL (University College London). In this article he sets out some of the ideas from his new book “Minding the Markets: An Emotional Finance View of Financial Instability” (Palgrave Macmillan) which describes an interview study with money managers and a new way of looking at financial markets. He has received critical acclaim from Nobel prize-winner George Akerlof and Bank of England Governor Mervyn King as well as Gerd Gigerenzer, Andrew Sheng and Dennis Snower, among many others. He is a Fellow of the British Institute of Psychoanalysis and won the 2007 Sigourney Award for Psychoanalysis. First trained in Economics and Medical Sociology, he also introduced behavioural sciences to medical education at the Middlesex Hospital Medical School and was Principal of the Health Education Studies Unit at the University of Cambridge.
1.For some investors it will be more complicated than this. In my interviews a number of fund managers will profit when the market is going down. So in this instance the remarks just made really apply to prices moving in the direction investors wish, or not, rather than to actual rises and falls.
2.Although my research focused on investment managers, the framework appears generalizable to the whole financial system. Certainly in any consideration of the financial intermediation role of the financial system – i.e. the channeling of savings to investment projects – it is investment managers who clearly have the most important role.
3.I am grateful to Greg Fisher for this example.
4.I have recently had opportunities to present the picture I have just drawn of financial markets to groups of money managers at two meetings of the CFA Institute. I also presented it to those I interviewed – in a follow-up series of interviews from February to April 2011. Although it is far from the traditional description in economics and finance textbooks, there was a rather universal agreement that the picture makes sense.