'Emotional inflation' leads to stock market meltdown

April 29, 2008

Investors get carried away with excitement and wishful ‘phantasies’ as the stock market soars, suppressing negative emotions which would otherwise warn them of the high risk of what they are doing, according to a new study led by UCL (University College London).

Economic models fail to factor in the emotions and unconscious mental life that drive human behaviour in conditions where the future is uncertain says the study, which argues that banks and financial institutions should be as wary of ‘emotional inflation’ as they are fiscal inflation.

The paper, published in this month’s issue of the International Journal of Psychoanalysis, explores how unconscious mental life should be integrated into economic decision-making models, where emotions and ‘phantasies’ – unconscious desires, drives and motives – are among the driving forces behind market bubbles and bursts.

Visiting Professor David Tuckett, UCL Psychoanalysis Unit, says: “Feelings and unconscious ‘phantasies’ are important; it is not simply a question of being rational when trading.

The market is dominated by rational and intelligent professionals, but the most attractive investments involve guesses about an uncertain future and uncertainty creates feelings. When there are exciting new investments whose outcome is unsure, the most professional investors can get caught up in the ‘everybody else is doing it, so should I’ wave which leads first to underestimating, and then after panic and the burst of a bubble, to overestimating the risks of an investment.

“Market investors’ relationships to their assets and shares are akin to love-hate relationships with our partners. Just as in a relationship where the future is unexpected, as the market fluctuates you have to be prepared to suffer uncertainty and anxiety and go through good times and bad times with your shares. You can adopt one of two frames of mind.

In one, the depressive, individuals can be aware of their love and hate and gradually learn to trust and bear anxiety. In the other, the paranoid schizoid, the anxiety is not tolerated and has to be detached, so the object of love is idealised while its potential for disappointment is ‘split’ off and made unconscious.

“What happens in a bubble is that investors detach themselves from anxiety and lose touch with being cautious. More or less rationalised wishful thinking then allows them to take on much more risk than they actually realise, something about which they feel ashamed and persecuted, but rarely genuinely guilty, when a bubble bursts. Again, like falling in idealised love, at first you notice only the best qualities of your beloved, but when everything becomes real you become deflated and it is the flaws and problems that persecute you and which you blame.

“Lack of understanding of the vital role of emotion in decision-making, and the typical practices of financial institutions, make it difficult to contain emotional inflation and excessive risk-taking, particularly if it is innovative. Those who join a new and growing venture are rewarded and those who stay out are punished. Institutions and individuals don’t want to miss out and regulators are wary of stifling innovation. If other investors are doing it, clients might say ‘why aren’t you doing it too, because they’re making more money than we are’.”

Source: University College London

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drknowledge
1 / 5 (1) Apr 29, 2008
The study is trying in a socially responsible way to make a point. All well-and-good. However there's an underlying blindness to a condition that has been reported in PhysOrg, which is that basically, there are people who like to gamble heavily, and there's no way of talking them out of it. One suspects that the emotional "highs" reported by the study aren't the cause of the problem, but merely the symptom of gambling behavior.
BenODen
not rated yet May 03, 2008
I'm not sure about that, drknowledge. Their observation is about both buying and selling. Gamblers could cause the bubble, sure, that makes sense. But if the bubble were only about gamblers the bubble wouldn't ever burst. Gamblers would keep investing on falling prices, keeping the prices fairly stable or rising out of the optimism that they'd make a killing when it went back up. So, some other group has to be the cause of the downward motion, I'd think, and there does seem to be a tipping point, where people panic which reeks of emotion over logic.

Their conclusion is all well and good, but I think the studies need to go on to the next step and figure out a way to use this knowledge to create more stable markets though. It seems to boil down to following the crowd as well, which doesn't make for stability.

I think that this most recent Real Estate crisis is not a bubble in the traditional sense. Real estate is now having problem because lending got seriously out of balance in the last X years, lending people money under terms that have no long term viability for those people. That risk was spread across the whole banking industry, sure, but what made the traditionally conservative banks so able to have the wool pulled over their eyes? They'd argue emotion, but it'd have to be collective rose colored glasses, as those investments in mortgage securities didn't happen with out some kind of accountability... Maybe the emotion lies in the buyers, who accepted these impossible terms, but wanted to have that home so badly that they ignored the risks. They wanted the home, mostly, not the rising prices. But in the end, I'd argue that the fall of the mortgage industry was in the end caused by the failure of the banking industry to properly rate the risks of these mortgage based securities, and I'm not sure why there's not been more investigations into conflict of interest. There was some talk of thse conflicts of interest in the Dot Com bubble, but nothing came of that either.
superhuman
not rated yet Jun 02, 2008
So what experiment supports their claims? Or are those just 'phantasies' of authors?

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