Richard Taffler tells WSJ investors need emotion

Professor Richard Taffler told the Wall Street Journal how new research suggests that rather than staying cold-blooded and rational the top fund managers use emotion to choose which stocks to buy.

Based on interviews with more than 50 experienced fund managers in the US, UK, France and Asia the Warwick Business School Professor of Finance and Accounting discovered how powerful a role their emotions played in successful investing in practice.

Professor Taffler found investors use ‘story-telling’, which webs facts and emotions together to convince themselves about a stock, with some referring to them almost as if they were lovers.

In their book, Fund Management: An Emotional Finance Perspective, recently published by the CFA Institute, Professor Taffler and David Tuckett, Visiting Professor at University College London, reveal how investors perform better when they acknowledge how emotion plays a part in their decisions and understand how to harness it.

Professor Taffler said: “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.

“Investors 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.”

With their money on the line Professor Taffler believes investors are bound to experience strong emotions, and entering into an emotional relationship with a stock or asset inevitably leads to anxiety because they can easily let you down. And Professor Taffler adds this “may not be consciously felt but will be bubbling beneath the surface”.

Investors deal with this anxiety through story-telling which gives them the conviction they need to buy the stock or put money into a company.

“A strong narrative links facts with emotions and creates the conviction which is absolutely essential for action to happen,” said Professor Taffler. “Investors need to be able to tell a plausible story to allow them to invest.

“One of the fund managers talked about investing in a fast-food company and 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.”

Fund managers are under acute pressure to perform and to meet such expectations Professor Taffler believes they look for something that in finance is the equivalent of Aladdin’s lamp.

“A very important insight in emotional finance is the concept of the fantastic object,” said Professor Taffler. “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 fund managers are required to be fantastic objects, to earn continuous superior returns at low risk. This, of course, is 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.

“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.”