Two professors, one of psychoanalysis, the other of finance, and both with expertise in economics and behavioural finance, have published a ground-breaking study on the real world of investment management that examines the role of emotions in investment decision making. Entitled Fund Management: An Emotional Finance Perspective (CFA institute research Foundation, 2012), the work is by David Tuckett, a professor in the Brain Sciences Faculty at University College London and a trained economist and medical sociologist and psychoanalyst, and Richard Taffler, a professor of finance at the university of Warwick in the U.K. and an authority on behavioural finance. It applies the psychoanalytical understanding of the human mind and dynamic emotional states explained originally by Sigmund Freud and developed by later psychoanalytic thinkers and analyzes in-depth interviews of 52 traditional and quantitative-oriented equity managers. The result is a set of unique insights into the psychology of fund managers, particularly the importance of storytelling to their ability to act in the face of uncertainty and cope with emotions that can threaten to overwhelm their thinking.

Emotion is central to all thought

Emotional finance differs from fundamental and behavioural finance because it focuses on financial decision making from the perspective that the outcome of decisions cannot be known in advance. Outcomes can be guessed at or imagined but never known, a fact that necessarily stimulates emotions that have an ongoing and dynamic influence on thought processes. Emotions have tended to be treated in both academic and professional circles as dangerous signs of weakness in an investment manager or sources of embarrassment and anxiety. Cold, rational calculation is idealized. This approach contrasts with the approach widely used in modern psychology and neuroscience, which has revolutionized the accepted academic understanding of emotion and its dynamic role in human behaviour.

Emotion or “gut feel” is central to all thinking and experience and is particularly important for reliable and accurate decision making. Far from being a hindrance, it appears to be an evolved capacity that has enabled human beings to survive, because it allows fast, efficient processing of everyday sensations and accords rapid meaning and purpose to all human activity. Thoughts, feelings, and actions are inextricably linked at both the mental and biochemical levels. In light of this evidence, Tuckett and Taffler maintain that attempts to treat emotion-based decisions as essentially weak or irrational are not simply outdated, they are seriously misleading.

In their interviews, the researchers found five recurring features of fund managers’ experience:

1. Fund managers were required to be exceptional. They must outperform their highly qualified peers on a consistent basis.
2. Fund managers must make decisions based on incomplete information that is open to competing interpretations. The decisions they make are always ambivalent and based on subtle interpretations of the meaning of inherently ambiguous information.
3. Fund managers know that investment valuations are determined by their own and their peers’ perceptions of underlying value and that these beliefs are neither obvious nor easy to ascertain. The future is uncertain, and the story that prevails about an investment’s likely future is what determines that investment’s current market value.
4. Fund managers know that the assumptions and reasoning that bind them to their claims about the investments they hold are uncertain. They hope to have the informational or interpretative advantage over their peers, but they know that the opposite may be true.
5. Fund managers make decisions by weaving stories for themselves and others out of incomplete information. Their stories help to commit them to action. Stories used to explain the relationships that fund managers have with their investments are highly emotional in nature. They are excited in their anticipations and disappointed when the future does not evolve as expected. The capacity for these relationships to gratify or frustrate constantly provokes emotion.

The role of stories

Stories are used to explain outcomes and, when decisions do not work out, to help the fund manager to carry on. Competitive daily pressures lead to anxiety, which can be antithetical to reflective and considered investment judgment. Coping strategies include selectively interpreting information and running several different portfolios at once so that at least some of them will perform well competitively at any given time. However, fund managers’ use of stories can mean that they, their employers, and their clients may have difficulty in learning from experience.

Tuckett and Taffler explore the risks fund managers face if their investment decisions do not work out. They perceive those risks as (1) uncertainty about the quality of the information on which they rely, (2) anxiety about their ability to predict the future, (3) doubts as to whether their clients will stay with them if they underperform (sometimes addressed by “index-hugging”), and (4) anxieties over their compensation and careers even if they are not responsible for underperformance. The authors note that conventional measures of risk, whatever their usefulness as actual measures, play an important role as pseudo-defences against uncomfortable emotions arising from uncertainties and risks by making fund managers feel they have gained a degree of control over risks.

States of mind

The authors identify the key role of “phantasies”—a psychoanalytical term that describes basic components of unconscious mental life—in all human activity and describe two states of mind in which decisions can be made: the integrated state and the divided state.

The integrated state of mind is characterized by the awareness of many ideas linked together in some degree of coherence but not in such a way as to exclude the potential of other ideas, particularly worrying ones. Ambivalence is felt and recognized, and uncertainty is accepted. The divided state of mind is characterized by the possession of many incompatible, strongly held beliefs without relationship to one another. Individuals repress or put beyond their mental awareness what they do not want to know, although it continues to exert disturbing influences on them. The world is seen in black and white, and when outcomes disappoint, the reaction is extreme and unrealistic.

The authors suggest that fund managers, who are required to be exceptional by their clients and employers, need to believe they can find exciting and idealized stocks to invest in that others may not be aware of—so-called “phantastic objects.” They need to think of themselves as phantastic objects as well, and in turn they are treated by their clients and employers as though they were. This causes all parties to function in a divided state of mind that is held together by group-feel or unconscious wishful thinking. People imagine, although they are only partly aware of it, that phantastic objects will satisfy their deepest desires to have exactly what they want. Tucker and Taffler originally applied the idea of phantastic objects in trying to under- stand the dot-com mania of the 1990s and other financial bubbles. Their latest research suggests that similar unconscious attractions are at work in normal market conditions.

Excitement, anxiety, and denial

Tuckett and Taffler conclude that the distinction between rational and irrational is highly misleading in finance for two reasons. Firstly, no investor makes decisions that seem irrational to them at the time. Secondly, in markets that are inherently uncertain and often over-loaded with both true and misleading information, it is very difficult to separate the rational from the irrational. In fact, any claim that investment decisions are made purely on rational grounds is an indication that ambivalence has been set aside and that thoughts are a product of a divided state. Investment activity is commonly thought to be driven by greed, fear, and hope; but to the authors, it is more clearly driven by excitement, anxiety, and denial state. To that end, the contribution that fund managers can make should be more realistically and explicitly recognized.

Viewed through the lens of emotional finance, fund management appears to involve a never-ending search for phantastic objects that unconsciously offer phenomenal returns with low risk. Clients and employers implicitly expect fund managers to successfully complete this quest. However, that expectation is largely unrealistic. Tuckett and Taffler argue that an industry that expects its rank and file members to be, and to seek out, phantastic objects clearly rests on problematic foundations. An industry that was operating in a more integrated state of mind would have to shun the belief in the existence of phantastic objects and clearly align the role of the fund manager with the interests of the majority of clients saving for retirement. Fund managers’ ability to consistently beat their benchmarks after costs is not very good, despite the extensive use of past performance statistics in ways that imply they can. A much better and more realistic comparison is with clients’ abilities to beat the market acting on their own. This demonstrates that fund managers can help clients to avoid losing significant amounts of money. Fund managers can also assist clients in overcoming their usually repressed, unconscious anxieties about having to invest when outcomes are uncertain. In the asset management industry, it is not necessary or desirable for fund managers to be phantastic and operate in a divided state of mind and group-feel in order for them to provide a valuable service. Rather, by operating in an integrated state of mind and being aware of the emotional conflicts at work, fund managers can look after their clients’ assets in a non-phantastic manner that is more closely aligned with their clients’ long-term objectives and interests.