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What caused the credit bubble? Richard Taffler, Martin Currie professor of finance and investment at the University of Edinburgh and David Tuckett, visiting professor in psychoanalysis at UCL, argue in the FT that the current debate lacks analysis of the role emotions play in financial activity.

“The solution to financial crises will not easily be found in increased regulation”, they argue. “Rather, it lies in understanding how a market in which a paranoid-schizoid state of mind is encouraged is inherently unstable.“

How crucial is understanding emotion’s role in investment? Professors Taffler and Tuckett answer your questions.

How do you measure awareness of the credit bubble? Did hedge funds expect the bubble to collapse and were they riding it in order to make profit on short sales? Is emotion’s role more important than a rational approach in investment today?
Olena Shelest, London

Richard Taffler: Needless to say it is not possible to predict when a financial bubble will burst although it is possible to recognise when we might be in such a market state both from asset valuations being out of line with underlying financial realities coupled with the dominance of a paranoid-schizoid state of mind in the market with doubters ignored and ridiculed. In response to the second part of your question it is not a case of either or. In psychic terms it is ”rational” to act ”emotionally”. What we are aguing in our article is the need formally to acknowledge the crucial role of emotion in all investment activity and what then derives from this.

Do you think there are any empirical reasons that can explain the summer’s crisis or was it all an emotional reaction to a few players who got their fingers burnt. If so what are the key emotional features you associate with the markets reactions? Do you anticipate that the market will now re-evaluate their pricing of credit risks (assuming that this is the reason underlying the market’s weakness this summer). Is there any way, as an investor, of isolating market variations caused by behavioural factors?
Washington Waithaka

David Tuckett: Perhaps there will be many in-depth efforts to explore the crisis and its causes. For now what we would like to stress is the fact that it is a common feature of market panics that they involve ”second thoughts” about something going on that was previously considered just fine. Usually, as in this case, there is no very strong new information - what changes is visibility and sentiment. Our view is that the trouble begins with what we term a PS state in which the excitement and accumulating success of as particular strategy is split off from awareness of the downside risk.

Split off means made unconscious - which means it’s there but not salient. When an (usually unpredictable) trigger occurs suddenly it is the downside only that is salient. This is why in the aftermath there is nothing but blame. The reasons we got into the mess are now split off and no one can imagine why they did such a thing. A D state involves working through the full picture

Would you say there is a distinct lack of financial/investing knowledge amongst the general investing populace, which leads to these self fulfilling prophecies of gloom? If so how can it be combated and by whom?
Glynn Parry, Chester

David Tuckett: Excitement and panic are contagious and lack of understanding doesn’t help.

But, by and large, financial markets today are dominated by sensible investment professionals who do not always operate in sensible ways – for the reasons stated in the article and elsewhere in this correspondence. The underlying problem is uncertainty – the future is inherently unpredictable and this is not so easy to bear – and, perhaps, the very limited theories so far brought to bear to understand behaviour. The concept of irrationality, for example, is much abused.

Richard Taffler: As we made clear in our article investment knowledge is not enough. Those caught up in the credit debacle include the largest and most professional investment banks, hedge funds and other leading investment institutions. No shortage of financial knowledge here.

The key issue is to recognise formally how easy it is to be carried away into a very excited state of mind which inhibits calm consideration and analysis.

With hindsight, it’s clear that the credit market was over-leveraged and that we are in the midst of an unwinding. It might be argued that structured products and derivatives enabled a much greater build-up of credit leverage and enabled more downstreaming of credit risk. Does it follow that structured product and derivative technology will enable the market to return to equilibrium more rapidly?
Kevin Corcoran, London

Richard Taffler: There are a number of interesting issues you raise. Firstly was the market really previously in ”equilibrium”? This is unlikely whenever a PS state of mind dominates, quite apart what the term equilibrium means in a market context.

Secondly, we argue in our article, that a major part of the problem was the widespread use of such enormously complex, opaque and ill-understood technology which also had the implicit purpose for many market participants of allowing them to split off, deny or avoid recognition of the true nature of their underlying very risky behaviours.

Continuing to use such technologies, which of course when used appropriately are very valuable investment tools, for the same purposes as before which your question implies clearly is not the way to restore confidence in credit markets and remove the high levels of distrust associated with the PS state of mind.

David Tuckett: We would stress the need for thought rather than technology - a good servant but a poor master etc. Intelligent sharing of risk may have great advantages - the problem we identify arises from a situation where there is emotional or other motivation to split off thinking about consequences from any current excitement.

Are financial crises a normal and inseparable component of market activity? Is there a clear-cut yes or no answer to that question?

Richard Taffler: Yes, unless we start to recognise the key role emotions play in allinvestment activity the repetition of such market states is inevitable.

David Tuckett: Markets operate inside social and psychological arrangements. The clear cut answer is that so far crises have proved inevitable but that it is not beyond human wit to construct social and institutional arrangements (based on psychological understanding) which can mitigate their likelihood. One could see the MPC as a step in that direction.

Instead of creating innovative, but complex, theories to describe the psychology of investors panicked by the collapse of the demand for equally complex and ”innovative” asset backed securities, would it not make more sense to look to the age-old emotions of greed and fear as an explanation for the current turmoil? What is the difference, for example, between the practices of certain lenders who failed to make the true cost of subprime mortgages clear to unsophisticated borrowers and then tried to conceal the resulting risk from investors through complex investment vehicles that no one now seems to be able to understand, and the accounting sleight-of-hand that ultimately brought down Enron? And in the absence of effective regulation and disclosure, who can blame borrowers, depositors and investors alike from being afraid to trust any part of the financial system, as Philip Stephens justifiably suggests is the case?
Roger Algase, New York

David Tuckett: Thank you for this good question too. There are several levels at which we can answer it:

1.It is characteristic after bubble type events that the initiators of new practices become blamed and sometimes put into prison. If there is deliberate wrongdoing this is no presumably appropriate. More often, however, there is an attempt to “project” blame from those who find it difficult afterwards to explain to themselves what they were doing onto any convenient target – with the consequence there is no learning from experience. In relation to “the practices of certain lenders who failed to make the true cost of subprime mortgages clear” (etc) we suggest there is need for careful investigation – we do know that in the dotcom IPO documents were exceedingly clear about the future of the companies everyone rushed to buy but no one took the slightest notice until afterwards. This is why we want to deploy the idea of a PS state of mind – in it “small print” that goes contrary to what one hopes to find may be ignored.

2.Clearly regulation is important but it is impossible and likely unproductive (inhibiting productive innovation) to frame rules that are so tight they cannot leave room for interpretation. At this point judgment and the states of mind we are interested in re-enter.

3.In further contributions we will link Greed to the rest of the argument. You are absolutely right to emphasise it – from a psychoanalytic point of view the greed to which you refer is a form of desire operating in a PS state of mind, where the rapacious effect of greed (and guilt etc) is split off into the unconscious.

Loved your piece in the FT, but I’m confused. Are you saying that a realistic view, which you label as (D) requires the recognition of risk, while any attempt to try to assess the risk in a sophisticated way in order to reduce it increases the chance that one will wind up in a (PS) situation? Are we to conclude, therefore, that you are suggesting that the combination of Adam Smith and Sigmund Freud means that ultimately we are doomed to the irrationality of both the psyche and the marketplace? (By the way, I’m in the philosophy department!)
Prof. Paul Eckstein, Bergen Community College, NJ, US

David Tuckett: Thank you for the very good question. Thinking that takes place in a “D” state will be fuller because it will be able to entertain outcomes which produce different feelings. Thinking in a PS state, for example excitement, is limited by the need not to have thoughts that spoil the fun. Sophisticated risk modelling is a tool which may help to identify risk but only if it is conducted in a spirit of real enquiry – i.e. with knowledge of the underlying logic and measurement principles and with the distributional assumptions being made.

We are referring to measures of volatility and the like which may have been used to giver security based on wishful thinking about underlying distributions. Taleb’s “Fooled by Randomness” is the text here. So, no, we are not doomed to irrationality and would actually question that notion: we are biologically programmed to be emotional, however, and can make no judgments of any sort without being in touch with them and the underlying fantasies giving rise to them.

I have long believed that in order to be ahead of the market you must understand and empathise how people behave en masse. To what extent do you believe this ”crowd mentality” has affected the perception of the recent credit crunch and the market’s reaction to it?
Alexandra Jackson, London

David Tuckett: Stock prices in markets always depend on anticipating future fundamentals (discounted cash flows or whatever) AND market sentiment towards stock. Sentiment is clearly contagious and a capacity to empathically predict attitudes would be valuable.

But the problem with anticipating the market is that you are always making (to yourself) a claim to be able to predict something inherently uncertain. You may or may not get lucky and you may or may not be able to assess the situation clearly enough to do better than chance.

In an era when companies compete to lend consumers money and in an era when borrowing money has not been easier, surely it is the bad practices of the reckless banks, rather than paranoid states of minds, that are responsible for mass panic?
Masood Soorie, London

David Tuckett: Good and bad practice are always much easier to assess after the fact. Professional investors are usually very thoughtful. What we have to explain, therefore, is how usually thoughtful people do with a certain regularity make judgments which they might not have made if they had attended, so to speak, to the small print of their own thinking. In the case of the banks the current problem is caused by a sudden realization that many of them do not know what risks exist in their own or other people’s balance sheets and so, sensibly, hesitate to lend to each other; the loans they had made (wrapped up in complex vehicles) existed before they stopped lending to each other but the risk had been “overlooked”.

Our argument about the PS state of mind is aimed at understanding how this can happen – as it happened when people seriously overvalued dotcom stocks. We draw on everyday psychoanalytic experience in which we frequently discover that thoughts rest on feelings. When one is excited at the prospect of a particular course one “puts out of mind”, that is splits off or somehow registers as non salient – thoughts that might give rise to feelings that “spoil” the excitement and replace it with anxiety or guilt.

Panic is a state in which there is anxiety and no time or place for thought – or where thoughts tend not be salient. It is particularly likely to happen if doubts about what was doing were split off and ignored.

Depression is a neurotic state of mind while, conversely, paranoid-schizoid state of mind is psychotic. Does this mean that the former is more in touch with reality than the latter in terms of perception of the current market?
David Newman, Brighton

David Tuckett: Before getting too much further into this we need to stress that states of mind are complex and the argument in the FT is necessarily simplified. The terms PS and D apply to two oscillating states which we are all likely to experience throughout our life from time to time. Neither is “better” than another and nor would we consider one neurotic and the other psychotic; although in extreme states that might be so.

The main point is that a PS state of mind involves more splitting of experience and affect and so is inherently partial – when we are first in love we often only appreciate one set of our loved one’s attributes. Later we may only appreciate negative attributes or we may take a more balanced view. The crucial point is that thought, judgment, is overlaid with feeling: we think only what we can stand feeling.

The current market, like any other, can be viewed in a balanced way as offering opportunities and risks but at times in the last few weeks active investors have tended to take only a partial view – at one time seeing only the upside and then later only the downside. Which view can be considered to reflect reality at which point in time is a matter of balanced judgment!

Do you consider the expression of emotions as a normal negative reaction to the execution of failing policies in economics and finances rather than a root cause of market crises?
Viktor O. Ledenyov, Ukraine

Richard Taffler: I think you have raised an important issue. We argue that a lack of understanding of how we can become caught up in very exciting behaviours in market situations and how we are reluctant to acknowledge what is really going on is a fundamental cause of market crises.

What we do once the bubble bursts is to avoid the pain of personal responsibility for our actions and blame others, central banks, regulators, credit rating agencies etc, i.e. in your terms failing economic and financial policies. In this way we do not have to recognise what we have done and thus have no opportunity to learn from this. As a consequence we are, in a way, doomed to repeat!

David Tuckett: We see emotions as part of all human judgement. The tendency of academic disciplines to ignore them (and subjectivity) is now being reversed in several fields. We think this will lead to many insights in economics and finance as well as in other disciplines.

Emotions are the motive force in financial markets. Given this, it does not then require extraordinary emotional states to account for market behaviour. Even at extremes, such behaviour need not be pathological. Any pathology in the markets would only exist by analogy anyway and would require that we had a working model of healthy markets against which to compare it. (It would also be interesting to see how you define paranoia and schizophrenia, neither of which admit of easy explication.) The markets are simpler than you think perhaps, but it may not be given to many market participants to categorise their situated behaviour in such a way as to understand what it is that they are actually engaged in.
Leslie Martin, UK

David Tuckett: We are not suggesting the market is pathological nor that emotions are the (only) motive force. Our argument concerns the normal role of emotional states of mind in the process of decision-making; in particular we are interested in how and why at certain moments what might be known does not seem to used in judgment.

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