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Extradry Martini

Are Btl Investors Paranoid-schizoid?

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Good piece today in the FT on market psychology. Applying psychology techniques to the analysis of markets is well-established in behavioural economics, but this is the first time that I (for one) have seen specifically Freudian techniques being used:

In the mood for instability

By Richard Taffler and David Tuckett

Published: September 20 2007 20:19 | Last updated: September 20 2007 20:19

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.

Q&A: Can the solution to financial crises be found in understanding the part emotions play in all investment activity? Post a question for Richard Taffler and David Tuckett .

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

The obvious and wilful ignorance of risks by most (but not all) BTL investors shows that they are firmly in the paranoid/schizoid phase.

Perhaps a simpler way to look at behaviour in markets is through a Pavlovian lens (remember Pavlov’s dogs were rewarded or punished for performing certain actions):

If someone does something and gets rewarded for it, he tries it again. If he keeps getting rewarded for it he will keep doing it. The more times he gets rewarded for doing it the more he believes:

1. In his right to be rewarded (which gets rationalized as skill in doing it - ergo right to be rewarded)

2. In the causal link between him doing something and being rewarded and therefore,

3. In the idea that he will always be rewarded for doing it.

All three are irrational, but they lead the investor to ignore risk. What eventually happens is that the investor is punished for doing exactly what he had previously been rewarded for. If he is nimble and exits his investment quickly (i.e. with a stop-loss strategy), he may try again and if he gets punished again he may (again, irrationally) stop doing it purely because he feels he has been punished too much. However, owing to a separate bias (that of not wanting to admit failure to oneself), most people who have been through the reward process are very unlikely to have a stop-loss strategy precisely because they have ignored the risks anyway. It is in these cases that the punishment is the most severe as the investor tends to hold on (still believing nos. 1-3 above) all the way down. In fact, it is only when the last one has sold that the market can recover.

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2 fundamental points ahve been missed here, particulary in regard to motivation:

1) Property investors were not all punished during or post the last crash and many that help ended up winning - I for one have met those that say 'if only I'd held onto that property'. Property investors have built considerable wealth compared to those who fiddled about with pensions etc.

JUST BECAUSE AN ASSETS PRICE FALLS DOES NOT MEAN YOU HAVE NO INCOME FROM IT - THIS IS KEY

2) Are we forgetting many property investors are motivated by the viscious PUNISHMENTS doled out by THE FINANCIAL SERVICES INDUSTRY, namely rip - off opaque endowments and personal pensions where the only beneficiary was the industry.

Such people are motivated primarily by being MORE in control of thier own destiny. For one they get to leave a portfolio to their next of kin whereas with a pension pot, it dies with you - as the good old Insurance co keeps the lot

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What eventually happens is that the investor is punished for doing exactly what he had previously been rewarded for. If he is nimble and exits his investment quickly (i.e. with a stop-loss strategy), he may try again and if he gets punished again he may (again, irrationally) stop doing it purely because he feels he has been punished too much. However, owing to a separate bias (that of not wanting to admit failure to oneself), most people who have been through the reward process are very unlikely to have a stop-loss strategy precisely because they have ignored the risks anyway. It is in these cases that the punishment is the most severe as the investor tends to hold on (still believing nos. 1-3 above) all the way down. In fact, it is only when the last one has sold that the market can recover.

Top article, many thanks for posting.

There was an article in new scientist a while ago that mentioned an experiment done on rats. There was a button that the first few times released food (reward). After a while they changed it to hand out an electric shock. The rats took a long while trying it again in spite of being shocked because they hoped that it'd go back to giving food. Then they largely gave up and left it alone, but even then every so often they'd come back and have a go just in case.

Supposedly showed how powerful the reward link is and how that past association will over-ride all current present evidence.

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Top article, many thanks for posting.

There was an article in new scientist a while ago that mentioned an experiment done on rats. There was a button that the first few times released food (reward). After a while they changed it to hand out an electric shock. The rats took a long while trying it again in spite of being shocked because they hoped that it'd go back to giving food. Then they largely gave up and left it alone, but even then every so often they'd come back and have a go just in case.

Supposedly showed how powerful the reward link is and how that past association will over-ride all current present evidence.

Apologies for not responding to this sooner. Yes you are right, and I have seen lots of people (including myself) doing this, but it tends to happen when you have a stop loss in place - they keep being stopped out and thena having another go. However, the level of conviction that many BTL investors have is so high that very, very few of them believe that the market will fall very much and even fewer would have a stop-loss in place. After all, as they say, those who sold in the 1989-94 bear market "must be regretting it now"...

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housing bulls and bears are alike, were all paranoid...

bears fear the housing market and believe in other market, housing bulls believe in the housing market but fear other markets...

Edited by moosetea

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housing bulls and bears are alike, were all paranoid...

bears fear the housing market and believe in other market, housing bulls believe in the housing market but fear other markets...

From the article:

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.

Someone tell Dogbox!

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2 fundamental points ahve been missed here, particulary in regard to motivation:

1) Property investors were not all punished during or post the last crash and many that help ended up winning - I for one have met those that say 'if only I'd held onto that property'. Property investors have built considerable wealth compared to those who fiddled about with pensions etc.

JUST BECAUSE AN ASSETS PRICE FALLS DOES NOT MEAN YOU HAVE NO INCOME FROM IT - THIS IS KEY

2) Are we forgetting many property investors are motivated by the viscious PUNISHMENTS doled out by THE FINANCIAL SERVICES INDUSTRY, namely rip - off opaque endowments and personal pensions where the only beneficiary was the industry.

Such people are motivated primarily by being MORE in control of thier own destiny. For one they get to leave a portfolio to their next of kin whereas with a pension pot, it dies with you - as the good old Insurance co keeps the lot

I agree with the sentiements nevertheless there are inherent risks in buy to let which many bulls seem to ignore. Geraing is risky that is why it gives a higher reward.

Its very easy to say I wish I hadh eld that property but if holding meant it bankrupt you how coudl you hold?

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I agree with the sentiements nevertheless there are inherent risks in buy to let which many bulls seem to ignore. Geraing is risky that is why it gives a higher reward.

Its very easy to say I wish I hadh eld that property but if holding meant it bankrupt you how coudl you hold?

Bulls will surely base thier decisions on the typical experience outcomes of others they have known over the years.

Bearish personalities will tend towards the poor outcomes experienced by relatively few.

Most bulls are well aware of risk, however they are also accutely aware of the long term consequences of innaction.

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[quote name='dogbox' date='Sep 21 2007, 01:37 PM' post='782126'

JUST BECAUSE AN ASSETS PRICE FALLS DOES NOT MEAN YOU HAVE NO INCOME FROM IT - THIS IS KEY

I think the key is there's no point in subsidising a falling asset as anyone who has entered the buy to let

market over the last few years will soon find out. You don't mind holding a falling asset if the income from

it is profitable (but even this wouldn't be my cup of tea). As we all know, most people who entered the

buy to let market over the last few years have been subsidising the mortgage payments out of their own

pocket. No profit there,and as prices fall the fear factor will kick in.

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There is a simple explanation of the BTL phenomenon...the madness of crowds + greed. This combination is as old as the hills. The next big thing? Could be tulip bulbs...it is time they came round again!

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