Cold Truth About Emotional Investing

Consider an excerpt:

WSJ: What do you mean by emotional finance?

PROF. TUCKETT: What we try to do in emotional finance is start with the fact that the future is unknowable. The key thing about uncertainty is that it inevitably generates feelings. Because it matters to you, because your money’s on the line, so to speak, you’re bound to feel emotionally engaged.

WSJ: Some people think pros are more rational than individual investors.

PROF. TAFFLER: Although most of the fund managers we interviewed saw part of their particular competitive advantage as remaining, as they described it, unemotional or rational, in practice they were just as emotional as anyone else when they started to talk about the stocks they had invested in. There were lots of examples where they referred to them almost as if they were lovers.

If you’re entering into an emotional relationship with a stock, an asset or a company that can let you down, this leads to anxiety, which is often not consciously acknowledged. But it’s there, bubbling beneath the surface.

WSJ: The fund managers told stories about their investments. What was the role you found that storytelling played in their decision making?

PROF. TUCKETT: They have to feel conviction. With a narrative you can join up different facts with emotions, and that creates a sense of conviction, and that is absolutely essential for action. So we aren’t saying “Oh, they’re only storytellers.” We’re saying you need to tell a story.

PROF. TAFFLER: One of the fund managers talked about investing in a fast-food company, how he visited the restaurants and looked at what people were ordering. The story was about seeing something nobody else could see, and that feeling gave him the confidence to invest.

WSJ: Could you talk about what investors expect from fund managers and what effect that has on the fund managers?

PROF. TAFFLER: A very important insight in emotional finance is the concept of the fantastic object. It’s like Aladdin’s lamp, which you polish and can have anything you want. In unconscious terms this is ultimately what we are all looking for.

The whole environment is problematic, because fund managers are expected to outperform on a continuous basis, in competition with other equally able and well-resourced managers, and of course not everyone can do this. So actually the fund managers are required to be fantastic objects, to earn continuous superior returns at low risk. This is, of course, only possible in fantasy, not reality.

To be able to do this, fund managers have to be able to believe they can find fantastic objects themselves, stocks with which they can have special relationships and which are going to outperform with minimal risk.

WSJ: With individual investors, I suppose it’s about managing the uncertainty of putting their money into the markets—it helps if they’ve got this idea of the star manager who can handle it all for them.

PROF. TAFFLER: Yes. In emotional-finance terms an important part of the fund manager’s job is to defeat uncertainty. In a sense we’ve got an institutional structure which seeks to deny that ultimately we’re all working in an environment that is inherently unpredictable.

WSJ: What can individual investors learn from your research?

PROF. TAFFLER: I’ve done separate research on individual investors, and of course they have all these same feelings writ large. You need to recognize that cognition and emotion go together; you can’t have one without the other. If you were coldly unemotional, which is of course not possible, then you wouldn’t actually be able to generate the conviction necessary to take the risk of investing.

Sums up many reasons why trend following excels.

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