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Perceived and actual risk in financial markets: insights from emotional finance

Thinkpiece 84

Former hedge fund manager Nick Bullman and Richard Fairchild of the University of Bath School of Management explain the importance of human emotions in investment and finance decisions.

Traditional approaches explaining human choices in financial services have done little other than reveal our limited understanding of this subject. Only in the last twenty years or so with the advent of "behavioural finance" have we been afforded a more colourful picture of the factors affecting peoples' decision making.

More recently, researchers have come to realise that far from making rational, robotic decisions, in fact emotions such as first impressions and "falling in love" actually have a more powerful part to play in the decisions of casual consumers and professional investors alike.

In this article, financial services risk expert and former hedge fund manager Nick Bullman teams up with Richard Fairchild at the University of Bath School of Management to explore some of these new theories and their implications to understanding financial markets.

  • The rational choice model assumes that financial market participants are fully rational, unbiased, emotionless self-interested maximisers of expected utility (with stable preferences).
  • A recent development, behavioural finance, recognises that real-world actors may suffer from bounded-rationality, may have psychological biases, may be captive to emotions, and may not be maximisers of expected utility.
  • The focus of this article is on a further, recent exciting development: emotional finance. Emotional finance employs Freudian psychoanalysis to study the effects of investors' and managers' unconscious emotions on financial market behaviour. 
  • Unconscious emotions may cause bubbles and extreme crashes at critical emotional tipping-points.
  • Emotional finance emphasises the difference between actual and perceived risk.
  • Investors' states of mind exists in two distinct phases: the paranoid-schizoid phase (when perceived risk is low), and the depressive phase (when the perceived risk is high).
  • Emotional finance predicts a dynamic inverse relationship between perceived and actual risk
  • Perceived risk may be at its lowest precisely when actual risk is at its highest.

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