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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. It draws on insights that Freudian psycho-analysis offers into how thought and feeling relate in the human mind.

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 (tulips, internet stocks, derivatives) 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.

Emotional finance recognises how uncertainty underpins all investment activity, although the consequent anxiety, doubt and stress are often suppressed. It also emphasises how reason often has little effect on judgment.

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. A paranoid-schizoid state is characterised by distrust and constant jittery activity, as currently manifest in markets.

Investors have to deal with uncertainty in terms of lack of information and the unknowable future. Both cause anxiety, creating opportunities to split off the “excitement” of a new investment from the “pain” of potential loss. 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.

Some market practices may have exacerbated the dangers. Complex risk measures used by investors are inevit-ably based on past market behaviours and can create the impression that the future is measurable. This allows trading to take place without participants fully realising the extent of doubt.

Emotional finance implies that all methods of risk assessment should be seen as ways of avoiding underlying uncertainties and anxieties. Their use can lead to deeper behavioural risk – the pursuit of exciting investment instruments, with insufficient attention paid to the downside risk.

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.

The brave new world of 21st-century finance (like the “new economy” of the 1990s) provides a vaguely plausible means of avoiding anxiety. It works as a cover story. 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. Distrust and panic can easily become a dominant feature; something notice-able when the queues outside Northern Rock branches did not easily respond to reasoned argument. Understanding the part emotions play in all investment activity should concern central banks, market regulators – and us all.

Mr Taffler is Martin Currie professor of finance and investment at the University of Edinburgh. Mr Tuckett is Leverhulme research fellow and visiting professor in psychoanalysis at UCL. Their paper, Emotional Finance: Understanding What Drives Investors, is published in Professional Investor’s autumn 2007 issue

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