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Thursday, September 20, 2007

Emotional Finance and Bubbles

Are we emotionally predisposed to the creation of bubbles?:

In the mood for instability, by By Richard Taffler and David Tuckett, Commentary, Financial Times: What caused the credit bubble? The current debate lacks analysis of the role emotions play in financial activity. The new discipline of emotional finance aims to show how emotion drives investors’ behaviour. ...

We tend to deal with anxiety in one of two states of mind: “depressive” (D) or “paranoid-schizoid” (PS). Applied to investors, in a D state they recognise the inherent unpredictability of markets, in which investments have both attractive and unattractive characteristics, and judgments are imperfect. A realistic view, in other words.

In a PS state of mind investors seek to avoid the pain of reality by separating good and bad feelings. Ideas that feel good excite, while those that feel bad are repressed. This allows investors to ignore the consequences of decisions, or to blame others for them. ...

In a D state, the risk of loss is evaluated against potential gain, so an opportunity is taken with awareness of potential losses. In a PS state, investors separate risk and reward and so do not think properly; there appears to be no downside to speculation. ...

All financial crises follow the same emotional trajectory: excitement at some new idea, domination of the market by the excitement, then jitters, panic and blame. The new idea ... creates a belief that something revolutionary is happening. This turns to euphoria and boom; emotions determine “reality”, as when internet stocks rose by 500 per cent in 18 months. A paranoid-schizoid state dominates and anxiety that might spell caution is denied. Doubters are dismissed. When the bubble bursts, we see panic and revulsion, then anger and blame, but surprisingly little guilt or learning. Typically, investors blame others for allowing them to be caught up. The sense of reality is still PS – because responsibility is disowned.

The credit bubble follows this pattern. Lending to subprime borrowers was overdone with the true risk apparently invisible. The “safe” assembly of high-risk loans into complex investment vehicles could only appear to eliminate risk if a PS state of mind was predominating. By “spreading” (avoiding) ownership of risk, such methods may even encourage irresponsibility. ... Calls for the authorities to take responsibility for the crisis again demonstrate how investors place responsibility and blame with others.

The solution to financial crises will not easily be found in increased regulation, more transparent information or cuts in interest rates. Rather, it lies in understanding how a market in which a paranoid-schizoid state of mind is encouraged is inherently unstable. ... Understanding the part emotions play in all investment activity should concern central banks, market regulators – and us all.

    Posted by on Thursday, September 20, 2007 at 03:42 PM in Economics, Financial System | Permalink  TrackBack (0)  Comments (11)

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