Practical analysis for investment professionals
27 July 2011

Research in Emotional Finance Suggests That Trying to Beat the Market Causes Emotional Conflict and Instability

Posted In: Behavioral Finance

Do your investment decisions involve emotions?

You may be inclined to think not, but according to Professor David Tuckett, a psychoanalyst at University College London, emotions are part and parcel of investment decisions.

A researcher in emotional finance, Tuckett is the author of a new book, Minding the Markets: An Emotional Finance View of Financial Instability.

He believes that we cannot make a single decision in life without involving emotions, which he sees as means for human beings to deal with uncertainty. Because they are full of uncertainty, financial markets must inevitably engage emotions, says Tuckett.

Drawing on research interviews that he conducted with 52 experienced fund managers in 2007, Tuckett shared his views with an audience of about 70 investment professionals at a continuing education event organized by the CFA Society of the UK on 12 July 2011 in London.

He describes emotional finance as a field that uses modern interdisciplinary theories of emotion to address the practical problem of making financial decisions under conditions of uncertainty.

David Tuckett

David Tuckett

Tuckett asserts that “emotional finance is fundamentally different from both standard and behavioural finance”. He explains that standard finance assumes that investors behave rationally and do not make errors in investment decisions, whereas behavioural finance suggests that investors deviate from rationality in their decision-making and make errors.

In contrast, in emotional finance, “the concept of error at the moment of making the decision is meaningless”, says Tuckett. That is, there is no correct answer at the time of investing.

Tuckett argues that it is impossible to beat the market consistently or to determine whether outperformance is due to luck or skill. Nonetheless, beating the market is the job of many fund managers. He believes that trying to do the impossible creates anxieties that affect realistic thinking. For example, even long-term investors may be judged on short-term performance.

Tuckett thinks that the fund managers trying to beat the market face “a fundamental dilemma”, like someone picking up dimes in front of a steamroller. If you are too busy looking out for the steamroller, you may not pick up many dimes and will underperform. If you are too busy picking up dimes, you may outperform initially but then get squashed by the steamroller.

This dilemma, claims Tuckett, could lead fund managers into an undesirable “divided state” of mind in which they may see only one side of things. For example, they may be driven to either love or hate dot-com stocks without really noticing it. This is the opposite of the desirable “integrated state” in which fund managers are able to take a balanced view.

Tuckett thinks that fund managers trying to beat the market use their imagination to create a story, such as why certain companies may benefit from new legislation on carbon emissions. This story, a combination of facts and feelings, gives fund managers “a sense of conviction” in the face of a constant flow of conflicting information, but it can be problematic if created in a divided state.

To beat the market, fund managers seek supposedly exceptional investment opportunities that may not exist in reality. Tuckett refers to these investments as “phantastic objects”, such as an innovative and enormously profitable way to generate energy.

Tuckett is of the view that competing for exceptional short-term performance by creating stories around “phantastic objects” serves no one. He believes that contrary to standard finance doctrines, such competition is destructive and causes instability.

The policy implication of Tuckett’s analysis is that professional investors, clients, and regulators need to take collective action to understand the role of emotions in investment decision making under conditions of uncertainty in order to avoid destructive competition and consequent instability in financial markets.

About the Author(s)
Usman Hayat, CFA

Usman Hayat writes about sustainable, responsible, and impact investing and Islamic finance. He is the lead author of "Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals," and the literature review, "Islamic Finance: Ethics, Concepts, Practice." He is interested in online learning and has directed three e-courses for CFA Institute: "ESG-100," "Islamic Finance Quiz," and "Residual Income Equity Valuation." The other topics he writes about are macroeconomics and behavioral finance. Previously, he was a content director at CFA Institute. He is a former executive director at the Securities and Exchange Commission of Pakistan (SECP). He has experience working in securities regulation and as an independent consultant. His qualifications include the CFA charter, the FRM designation, an MBA, and an MA in Development Economics. His personal interests are reading and hiking.

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