Another Crowd is pleased to offer a guest post by Ian Anderson, the Chief Operating Officer of Archover. Ian takes as his topic Emotional Finance, the study of how our emotions drive our investment decisions, for worse, and for better.
This article was originally posted on BankNXT and is reproduced with the author's permission.
In my day job as Chief Operating Officer of fintech firm ArchOver, I’m lucky enough to occasionally work alongside Richard Taffler. Richard is Professor of Finance and Accounting, and head of the Accounting, Markets and Organisations Group at Warwick Business School, and advises us on credit scoring.
As an advocate of fintech, and an active investor, I’m fascinated with how little we develop opportunities in investment and banking that appeal to our emotions. As the world of banking and investment evolves to be more customer-focused, we’ll need to understand and develop ‘emotional’ elements to attract audiences. But what exactly is emotional finance? According to Richard, emotional finance is a new paradigm in the understanding of investment activity, and prediction of asset prices and market behavior. It differs from traditional finance theory, which is based on the idea that investors are ‘rational’, and behavioral finance, which, although recognizing that investors are prone to bias, nevertheless implicitly assumes they can still learn to be rational.
Richard’s view is that emotional finance recognizes that people are inherently irrational and largely driven by their emotions, some of which they are consciously aware of and (more importantly) some they’re not. The latter is more powerful, because these emotions are not directly accessible to the conscious mind.
Neuroscientists point out that at least 95% of our mental activity is unconscious and how, in practice, action precedes thought and conscious awareness. Emotional finance draws explicitly on the insights of the psychoanalytic understanding of the human mind to describe how unconscious processes drive investment decisions and market dynamics, and are an integral part of all financial decision making.
The Emotional Finance Framework
Richard’s view is that by directly acknowledging the vital role investors’ unconscious needs, fantasies and drives play in their investment judgments, emotional finance provides a very practical framework that can help explain and predict those aspects of investment decision-making and market activity not open to rational models and conventional perspectives.
Research shows how market participants ultimately ‘feel’ decisions rather than consciously make them, despite what they appear to believe. Emotional finance directly recognizes the important role ‘illusion’ and the associated desire for ‘wish-fulfillment’ play in this process. Investment decisions are, in effect, the outcome of a struggle between unconscious feelings of ‘excitement’, the pleasurable idea of potential future gain, and ‘anxiety’ – the pain of potential future loss.
An important insight of emotional finance is how some types of investment, known technically as phantastic objects, represent exceptionally exciting and desirable transformational wish-fulfillling fantasies in unconscious terms. This can help explain such things as Bernie Madoff, dot.com stock valuations, the apparently magical nature of derivative products, the way some hedge fund managers are viewed almost like gods and even, more prosaically, the mispricing of individual stocks and, one could argue, fintech unicorns.
Emotional finance also recognizes how markets constitute large virtual groups with behavior reflecting the interaction of the often unconscious drives, needs, emotions and desires of their participants as they try to deal with the inherent uncertainty of the investment process and associated anxiety.
Richard’s view is that markets take on their own unconscious mental life and are prone to act out the same emotions as individual investors, such as excitement, euphoria, panic, depression and mania. Importantly, by drawing on the insights of group psychodynamic theory, emotional finance can help explain why markets behave as they do, and different market states including asset pricing bubbles, such as the rerun of dot.com mania and the Chinese stock market bubble, as well as many aspects of the global financial crisis.
It’s a fascinating topic and one that will no doubt play a part in how fintech and investment products develop.