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Wading through Irrationality: Demystifying Emotional Finance

By Saumya and Sanya Seth

We use the word ’emotion’ at the drop of a hat since it is so frequent in our language. When asked to define it, though, it leaves us bewildered. One of the numerous reasons for the interpretation’s subjectivity is because it has cognitive, physiological, social, and behavioral elements, making a formal definition of the term difficult. The usage of the word ‘emotions’ in this article is not merely synonymous with feelings; it refers to evaluative mental states having positive or negative implications that may be quantified using bipolar scales such as the gamut from pleasantness to pain. 

Since the beginning of time, traditional financial decision-making has been based on logic, arithmetic, and statistical measures, neglecting emotions. The theory of rational expectations in finance posits that each investor makes reasonable (Rational) judgments based on their unique market information and experience. The idea of emotion playing a role in  decision-making has thus been vastly neglected. While an amateur’s perspective promotes the understanding that cognition and emotion are in conflict, a professional’s perspective promotes the idea that cognition and emotion are complementary. Many psychologists argue that emotions do affect decision-making in myriad ways, but the effects aren’t always negative. Renowned neuroscientist Damasio has produced path-breaking work to highlight the implications of the absence of emotions in the process of arriving at financially sound decisions. Damasio proposes a link between faulty reasoning and canned emotions. As a result of the frequent crossing of the two, the theory of Emotional Finance was investigated under the umbrella of Behavioural Finance.

The theory of Emotional Finance

Emotional finance studies how conscious and unconscious emotions influence investors’ individual decision-making that come to climax markets’ development. Emotional finance market participants, unlike standard economic models based on economic logic, operate based on their own reference points; drawing on psychoanalytic expertise and an understanding of human mental processes, according to scholars. This reliance has been demonstrated through several trials in which decision-makers have been observed acting in direct opposition to the axioms of rationality. The Prospect theory builds a paradigm, as investors choose loss-aversion at the cost of irrationality: profits and losses are valued asymmetrically as a preference over the utility derived from them. This explains why investors hang on to loss-making equities for long enough to avoid losses, yet sell profit-generating stocks quickly enough to realize gains.  This is due to the fact that people make judgments based on their assessments of the implications of various emotional responses. They have a propensity towards making decisions that reduce or eliminate the chance of negative feelings like regret, anxiety, and so on (choose psychic reality over rationality). Thus, emotion is a key factor in a trader’s ability to withstand the vagaries of financial markets.

Using investor emotions to deal with risk and uncertainty

At the heart of financial market developments lies the discourse on risk and uncertainty. Here, risk denotes the quantifiable, observable aspect of the future, whereas uncertainty denotes the intangible, unobservable, and unknowable aspect of the future. Examining risk and uncertainty through the perspective of emotional finance necessitates a thorough analysis. It distinguishes conventional measures of risk, entailing the usage of probability distribution models for predicting outcomes; from the real risks associated with the anxieties of investors. In this new financial paradigm, statistical risk measurements and simpler decision-making procedures serve as pseudo defenses (emotional comfort for dichotomies) against genuine hazards.  

Analyzing the influence of a short-term problem-solving technique on judgments is important in the case of unpredictable occurrences, as evidenced by black swan events such as the 2008 global financial crisis. As a result of the uncertainty, decisions are made based on short-term incentives, which may turn out to be suboptimal or flawed in the long run. Emotional finance emphasizes the importance of emotions such as trust and faith in reducing investment-related anxiety brought on by an uncertain future. Investment consent is unattainable when there is a lack of trust; trust provides an “illusion of control,” which is critical when investing in an asset whose future value is uncertain in a dynamic market .Emotions support logical decision-making in times of uncertainty or approaching danger. As a result, despite the predominance of future uncertainty, companies’ collective belief (faith/trust) in the financial market offers the confidence to invest.

Bubbling up Trust: Explaining herd behavior in financial markets

Though trust plays an important role in dealing with uncertainty, it also causes herd behavior.

The truth effect, which is generated by imitating the actions of other market players while ignoring realistic facts, causes herd behavior (akin to the backfire effect). Investors’ herd tendency causes them to assign prices that are different from the inherent and innate values. Surprisingly, this herd tendency has been proven to occur at times of market stress. According to herding behavior, market whims force investors to focus intensely on the individual components of their investment-related decisions, pushing them to rely on the market’s collective knowledge. Due to the herd’s inclination to be swept away into fight or flight, a sequence of irrational actions can occasionally act as a catalyst for baseless market rallies and selloffs. Even Dierks and Tiggelbeck paint this causal relationship between emotions, herd behavior, irrational overvaluation, and speculative bubbles or financial crises. Therefore, deploying the psychoanalysis of moods and group dynamics that aren’t being noticed facilitates emotional finance to justify the reasons behind recurrent financial meltdowns and asset bubbles.

According to Kindelberger and Aliber (2011), so-called irrational occurrences such as speculative asset pricing bubbles are caused by a five-stage emotionally motivated trajectory. 

The Dotcom bubble in the United States in 1995 is a good example that can be scrutinized. Investors’ early enthusiasm for market innovation causes euphoria and (in some circumstances) repudiation. The classic illustration in Cassidy’s historical perspective is how internet stocks were perceived as a fascinating phenomenon in the media during the period. However,  situations when illusions are broken, such as bubble collapses, are connected with feelings such as trepidation, followed by a hue and cry. Asset price bubbles are seen as the byproduct of a disruption in the market’s perception of reality caused by an exciting new notion that catches the financial imagination, and a shift from the people investing on a factual basis to judgments based primarily on pleasure. For instance, in the case study being considered, the Dow Jones Internet index rose to its peak(by 500%) in an 18-month period ending March 2000.  Here, this financial imagination was approached with defiance of or suppression of fear, while the emotional conflict was driven away by anything that may have contributed to negative sentiments, as the market operates on the core assumption of group functioning. When reality sets in, however, panic replaces the euphoric euphoria, and market participants are left with nothing but hatred, sorrow, and regret for their previous financial illusions. It has to do with the fact that when restrained anxieties can no longer be rendered unconscious, bubbles explode. The boom burst in March 2002, for example. The prices of all stocks irrespective of their relationship with the internet were affected and as a result, the S&P plummeted by 40% over three years. As a bogus refuge or escape from their own feelings of guilt for previous financial errors, investors turn to blame games and fury.

While the so-called wisdom of the crowd eventually led to the creation of an asset price, we can’t say that irrational phenomena should be avoided because the creation of the bubble had some unexpected positive consequences, such as encouraging investors to seek out sustainable business models and allowing small and lean businesses to grow.

Finally, it’s critical to assess if allowing human irrationality into a traditionally logic-based subject is doing more harm than good. Is it appropriate to hold people liable for inadvertent financial decisions made in a confused state of mind?

As of yet, there are no definitive answers to these questions, and there’s a need for further research in the field.

Saumya and Sanya Seth are currently students at Ashoka University

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