Richard Taffler on Emotional Finance
Two sessions featuring academics today illustrated why this is one of our favourite events on the pro-am hedge fund conference tour (see Tuesday’s posting if you don’t know what we’re talking about). One session dealt with the intersection of investing and emotion while the other addressed how one particular emotion â€“ greed â€“ may be the driving force behind at least a few hedge funds (who knew?).
Richard Taffler is a finance and accounting professor at the University of Edinburgh with an uncommon command of psychology. He is one of the proponents of a new field of study called emotional finance (see a previous guest posting on this topic). Unlike its close relative behavioural finance, Taffler’s emotional version focuses on the deep psychological affirmations received by making particular investment decisions. His presentation borrowed from psychoanalysis and was probably the first presentation we’ve ever seen at a hedge fund conference that included the words Freud, Oedipal, and infantile.
He puts this framework to use by attempting to explain the collective delusion investors experienced during the dot-com bubble (see his academic paper on the topic â€“ actually quite readable).
It’s hard to argue with his central thesis that investors became caught up emotionally with the drama leading to market prices departing in such an extreme way from fundamental value. But his model provides a rich set of tools to understand the specific process by which rational investments eventually became something the ownership of which was felt able, magically, to transform an individual in unconscious phantasy from a normal kind of existence into an omniscient and omnipotent one. (phantasy is a technical term he uses to describe the investors unconscious, yet organized vision of success.)
Taffler builds on the market bubble literature to propose 5 emotional stages through which bubbles must progress:
- Emerging to View: Journalists catch on and the hype begins â€“ establishing the investment as a phantasy object.
- Rush to Process: The security begins to elicit compulsive behaviour and becomes the object of an intergenerational rivalry (former dot-com entrepreneurs: you know what I’m talking about.)
- Psychic Defense: Doubt creeps in but is quickly quashed due to a sense of triumphalism on the part of investors.
- Panic Phase: Everyone freaks out, exits the sector and goes back to their marketing jobs â€“ causing stocks to be viewed as shameful.
- Revulsion and Stigmatization: Yes, it gets worse… An experience of loss is met by a quest to condemn someone else for getting investors into this pickle.
Ah, sweet memories of the dot-com days, eh? They simply don’t do hysteria like they used to.
Or maybe they do. If you’re looking for a modern day allegory, Taffler suggests you needn’t look too far. New types of securities (e.g. CDOs) has recently undergone a panic and are now met with revulsion and stigmatization by many investors.
In fact, the hedge fund industry itself may be the next in line, mused Taffler. The psychological desire to invest in a superstar manager and experience a sense of vicarious invincibility may be the motivation of at least a few hedge fund investors, Taffler suggested.
He seemed somewhat less committed to the strict application of his framework hedge funds â€“ perhaps because the hedge fund managers in attendance had locked the doors and were beginning to menacingly pound their tables in unison by this point â€“ but more likely because he recognizes the wide diversity of investments that fall under the banner hedge fund.
Peyton Young: Compensation formula at the heart of the problem
Soon after Taffler showed how we were all “paranoid-schizoid”, Professor Peyton Young of Oxford University and the Brookings Institution took the podium. Young, as you may recall, co-authored a paper last fall on how hedge fund managers could easily just sell options and claim the premiums as “alpha”. While the hedge fund industry is used to this criticism (it has been levelled for some time by hedge fund replicators with non-linear factors in their models), the popular media latched onto the argument in the winter and spring. The chief economics correspondent of the Financial Times gave it some serious legs a couple of months ago (see posting).
Young’s concerns about hedge funds are based on the oft-cited free option created by the asymmetry of performance fees (i.e., a hedge fund manager can win, but she can’t lose). Says Young:
Under any incentive scheme that does not levy penalties for underperformance, managers with no investment skill can game the system to earn expected fees that are at least as high, relative to expected gross returns, as they are for the most skilled managers.
Naturally, selling options, earning a premium and hoping that the world doesn’t fall apart is a relatively sure-fire way to make money â€“ until the world falls apart and you have to pay the piper. Peyton uses the technical moniker “quack” to describe such a manager.
So how could any investor fall for this trick? Because they simply aren’t aware of it, says Young, due to a lack of transparency.
I asked Young whether transparency was a silver bullet. Even with position-level transparency, however, it can be hard to separate the short-volatility strategy from the deadweight positions that can so easily obfuscate the picture. In addition (as Young also says in his paper), managers with the best intentions could make a series of active decisions that inadvertently replicate a simple short-volatility position. Young acknowledged the limitations of transparency, but maintained that it was a good first step.
He also proposed greater regulation and professional standards as another way to reduce the potential for fake alpha.
He said that third-parties could analyze and monitor hedge fund managers to verify the authenticity of their alpha. The problem is, who? As one audience member pointed out, this was a business that none other than Bear Stearns, Goldman Sachs and the rating agencies were looking at before it became apparent that this might be a case of the wolf guarding the hen house.
Despite being made a bit of a poster child for the anti-hedge fund crowd, Young is actually quite dispassionate about the issue (again, it could have just been the rotten tomatoes and eggs being handed out at the back of the room). He was quick to acknowledge the complexity of the issue and also acknowledged the media’s propensity to exaggerate some of his arguments, or at least to cherry pick certain elements of it.
Thus ended the three-day gabfest that featured over two dozen sessions on topics ranging from the pragmatic (130/30, alpha/beta separation) to the ethereal (Is simplicity the new complexity?). Back over the pond now. Too bad they don’t have Wifi on the plane.