Analyzing the mirror image of the dot.com mania — Emotional Finance: for better governing the stock market

This work was one of the very best analysis reports for The Psychology of Investing and Financial Decision Making at Warwick Business School.

Guided by emotional finance, we are concerned that the current stock market is a mirror image of the dot.com mania, which is frothing at the stage of rushing to possess (Submitted Date: 28th July 2021) and heralds the manic denial soon.

Although the inevitability of investors stepping into the same river seems unbreakable, policymakers could seek ways to protect investors and better industry governance through perspectives of public education, professional regulations, and academic research.

To cite this digital scholarly public market commentary:

Wu, J. 2022. Analyzing the mirror image of the dot.com mania — Emotional Finance: for better governing the stock market. [online]. [Accessed 28 May 2022]. available from: https://www.dhirubhai.net/posts/jwusln_activity-6936442797973504000-fUMM?utm_source=linkedin_share&utm_medium=member_desktop_web

1. Introduction

In the form of management reports to the national committee of the finance industry from a committee member, this report is to draw the committee's attention to why and how financial bubbles recur due to people's unconscious processes; and explore how to make the industry better governance.

The following section reviews the five path-dependent emotional stages (Taffler, 2018) of the dot.com bubble and their comparisons with the current market; then, the market outlook is offered. Section 3 examines the similarity between the stock investment and gambling for diving deep into the psychic cause of recurrent bubbles in its essence. Before the conclusion, Section 4 proposes the potential policy directions grounded on understanding emotional finance and behavioural finance relevant to the current market.

2. A mirror image of the dot.com mania

The current market is the mirror image of the dot.com mania, representing the intact emotional finance paradigm where the asset bubble starts and bursts. Taffler’s five-stage emotional finance model can be used to illustrate the changes in emotions and (emotions)-induced behaviours from Emerging to view, Rush to possess, Manic denial, Panic, and Revulsion and Blame. The origin of dot.com mania is people's search for phantastic objects. Instead of new information or knowledge, the birth, growth, and burst of the internet bubble resulted from the market participants’ active search for phantastic objects to phanatical admiration, and blind support regardless of criticism, hatred, and outward blame.

By reviewing and comparing the dot.com bubble and the current market in the paradigm of emotional finance, the true colours of the present market and the myths of its near future are taken out of the market appearance.

2.1 The reappearance of the mania birth

With a psychological lens, considering the three aspects regarding the appearance of index price dynamics, the pursuit of phantastic objects as the driver, and the PS state of mind (Bion,1970) developed from Melanie Klein’s (1935) psychological concepts of paranoid-schizoid behind the scenes of phantastic objects, the nature of the dot.com mania birth and how the current market was shaped is the same. First, the recent market anomaly emerged into people's eyes through a similar appearance of index price dynamic as the dot.com bubble (see Table-1).

Driving by a similar group of phantastic objects is one of two in-depth common grounds emotional finance penetratingly detected through the similarity in the appearance of index price dynamic. The same attribute on the emerging stage of these two anomalies is that tech stocks, the psychological engine to ignite the origin of excitement, began to enter people's eyes with excellent financials and stock price performance.

After being equipped with this capability to capture the financial imagination, tech stocks possessed the ability to supply pleasures as phantastic objects. The gradual stock price increases of well-performed firms constantly exuded excitement to increasingly more investors and thus, attracted attention and buy-in. Finally, the excitement about these phantastic objects exploded in front of the world, causing huge spikes in the stock price (see Table-2).

The other common power (of dot.com bubble and present) behind the scenes of phantastic objects driving index price dynamics is that investors psychologically changed from the D state of reality-based thinking embracing conflicting and comprehensive information, to the PS state of wishful thinking, which only valuable information for satisfying the purpose of pleasure (Bion, 1952).

Due to the operation of the PS state, investors formed and joined the basic assumption groups where people imaginatively believed they were collectively supporting the common pursuit of phantastic objects with the same psychological state. As the support to the pursuit, the PS state of mind seeks pleasures and external support to rationalise the PS sense of reality where phantastic objects exist and are omnipotent and split conflicting feelings or news about phantastic objects off to the unconscious.

The examples of interest rate dynamics (see Table-3, e.g., the size of rate cuts had dropped exponentially, nevertheless market increase more) illustrated that it is not simply the pleasures or external support that froths bubbles but the PS state pat on the back of people's pursuit for phantastic objects. Back to the current market, the rate hikes and the US-China trade war (2018-2019) did not stop the Nasdaq step up. Besides ignoring the facts and undermining the boon of information, the PS state splits away bad information that already existed, thus making people focus on pursuing.

2.2 The recurrence of the bubble growth

The carried on 'pursuit' towards phantastic objects by increasingly big basic assumption groups operating in the PS state inevitably pushed the market anomalies onto the second stage, a rush to possess where the current market shares essentially the same evolution with the dot.com bubble.

In this stage, the financial performance of phantastic objects could no longer single-handedly explain their valuation. Table-4 shows that in either the dot.com bubble or the present, the glamour of innovations, which used to be prominent features of the phantastic object, could no longer deliver financial performances striking out alone to make up for the dramatic overpricing. Still, investors who were afraid of missing out began to rush to possess the phantastic objects, and thus the stock prices increased with low anxiety. Why?

The answer is that, instead of being a lone wolf, legitimated by the other two musketeers — the cover stories and spiritual leaders of the basic assumption group, phantastic objects which centred on three musketeers remained as the locomotive of the rocketing-up market. It did not lose the power of active incitement but further enhanced its charisma by narrating (Dumanl?, 2019) more pleasure and reducing anxiety.

The brushed-up cover story, which was not new information but met the needs of PS state on seeking pleasure information, is an insight the dot.com mania and present market have in common. In the internet bubble, the information about the transformation of the economy had existed for a long time but was heavily headlined by media until the rush to possess stage after 1998, as examples collected in Tuckett and Taffler (2008)'s research. Hu et al. (2021) pointed out that while the traditional sectors had been sluggish, the information and communication technology industry, which accounted for nearly 6% of GDP in 1998, had been growing rapidly since 1990 from 3.4%.

This time is pushing the same old buttons in stone-age brains. As superficially plausible and popular stories of tech firms rehashed by the rhetoric media and basic assumption group rationalise unrealistic financial imaginations on phantastic objects. The representative one is that omnipotent Tesla could not only send rockets to the sky but also seemed to be able to conquer Mars (Waters, 2020). Not only are current technologies more disruptive and beat the COVID-19 given tech firms have productivity in virtual work, but also Facebook wins antitrust lawsuits (Murphy and Stacey, 2021).

The care that the basic assumption group needs from spiritual leaders is another similarity enhancing the power of phantastic objects and reducing the market’s anxiety in the two anomalies.

There was no new policy from the leaders helping eliminate anxiety and amplify excitement that the PS state of group thinking requires; instead, it was the leaders’ repertoire as doctrines of phantastic objects (Galbraith, 1993; Smelser, 1998). Although the federal interest rate dropped from 5.25% to 4.75% in a rush to possess stage, which was not larger than the adjustments from 1995 to 1998, the market index raised more stunningly. Thus, the key was not how policies changed as the policy has its sustained mechanism, but Alan Greenspan was assumed as the omniscient guru protecting the market (Greenspan, 1997). And this is also how the current market is moving now. Those in authority meet the needs of the phantastic dependency by playing charismatic saviours (i.e., Jerome Powell; Smith et al., 2021) who will boost the economy post-pandemic and provide security for everyone (Bion, 1952).

2.3 The prospect, manic denial and burst

The psychological playbook of the internet bubble implies the stage of manic denial will come soon in the current market because the equities will be questioned as to their soaring valuations. Meanwhile, phantastic objects back-to-back with the other two musketeers will not be enough to embellish the overpricing (Table-5).

However, the psychological nature of PS state, the pleasure principle (Freud, 1911) would mentally separate the bad feelings and information to be repressed and rendered unconscious, unrealistically exaggerate qualities of phantastic objects, repudiate with disavowals to the external reality to diminish or avoid the painful effects associated with that reality (Auchincloss and Samberg 2012). In this way, unconscious, and excited ambivalent object relationships of attachment and attraction with phantastic objects (Tuckett, 2011) would be protected.

The reviewed dot.com bubble illustrates what will happen soon based on how PS state of mind deals with the frustrating conflicts such as the stock price of phantastic objects and their reality of further value decoupling. In the Fight-flight (Bion, 1952), the basic assumption group rode previously discovered or developed weapons of cover stories and spiritual leaders out to fight with sceptics or live in their wishful inner world. Sceptics, even Shiller (2000)’s sophisticated warning, were ignored, attacked, or even treated with contempt and dismissal (Cassidy, 2002; Kay, 2003).

Then, new strength will refuel the phantastic objects like what happened at the dawn of the 21st century. After the barrage of heavy fire from the three musketeers, the professionals were loathly forced to be reluctant reinforcements of the basic assumption group. Otherwise, they would lose their jobs or clients (Tuckett and Taffler, 2008). Having to adapt to this new reality, institutional investors (Kay, 2003), including those substantial passive funds, would join the team betting on Nasdaq (Griffin et al., 2011). Driven by tremendous buy long power, the Nasdaq IXIC peaked in March 2000. This is also what will happen at the next stage of the current market.

On a longer-term horizon, the market will collapse with panic, then become an intact mirror of dot.com mania where the last stage is full of blaming scapegoats. It cannot be certain what will be scapegoats meeting the psychological needs of a continuously dominated PS state where projections unconsciously attribute unwanted feelings to others (Auchincloss and Samberg 2012). Still, as the dot.com bubble has shown, any scapegoat would not represent new information and had not held back the market (Table-6).

It is unknown when the manic denial stage will come (although soon) and when the panic and bubble burst will show up because the inability to predict the future is the nature of the stock market. However, that is the context of this uncertainty (Ricciardi 2008) where emotions (Galbraith, 1993; Kindleberger, 2000) operated by the PS state of mind will continuously determine the way reality is apprehended, and thus investors would psychologically entrap themselves in the same path-dependent emotional trajectory (Tuckett and Taffler, 2008).

3. The ‘stepping into the same river’ mystery

The inevitable recurrent path-dependent emotional trajectory can be attributed in its essence to the gambler nature of stock investors, which keeps investors unconscious searching for phantastic objects and makes investors prone to operate with the PS state of mind.

Gambling and stock investing produce the same emotions and psychological functions (Rosenthal and Rugle, 1994) in participants with many common psychological traits (Statman, 2002; Kumar, 2009; Jadlow and Mowen, 2010). Moreover, both activities can enable people to escape their pains with a divided state of mind (Schull, 2012) and are both easily addictive (Konstantaras and Piperopoulou, 2011).

Even professional investors are not immune to having this gambler nature because stock trading, like gambling, involves the concept of predicting the future and controlling risks. As the gambling industry (APA, 2013), professional investors are trained in forecasting, discipline, and risk control. However, in response to uncertainties that are unidentifiable, immeasurable, and unknown (Ricciardi, 2008), Risk measurements are mainly used to provide emotional comfort in a divided state of mind to professionals (Tuckett and Taffler, 2012) with the gambling liken omnipotent control (Segal 2008) on investment outcomes.

Therefore, it is impossible for investors not to ‘step into the same river’ as the psychic reality of the stock market they engage in is gambling.

4. Implications

Nevertheless, such inevitability is not a pretext for policymakers to let investors simply be puppets of financial-psychological ghosts, and especially most investors have not yet understood the manipulation hidden in their unconscious (Tuckett and Taffler, 2008). Interventions could be grounded on understanding emotional finance and behavioural finance relevant to the current market more generally.

The kaleidoscope of cognitive heuristics biases are loopholes where phantastic objects can enter and gain people's emotional attachment. Although different investors have different cognitive biases, these biases can explain the specific conscious reasons why individuals buy certain equities. Such conscious reasons in the brain could enable investors to accept ‘new reality’ at the conscious level and make people's unconscious minds more defensive to outside scepticism when maintaining beliefs in phantastic objects.

The economic outlook is usually expected to be a possible environmental boon for phantastic objects, but this availability bias easily ignores other critical factors. For instance, current deglobalization may slow the economic recovery. Some may believe, a bull-trend of phantastic objects is difficult to reverse, but these ‘chartism’ and optimism biases cannot predict the future.

Understanding cognitive biases are vital for recognising the risks associated with phantastic objects, even for people operating the D state of mind, which accepts the conflicting reality. However, poor financial literacy puts off investors from avoiding cognitive traps. Therefore, it is worth considering merging behavioural and emotional finance into the compulsory education systems in developed countries to increase public financial literacy as they are complicated and have a better start with kids.

However, these conventionally viewed ‘cognitive’ biases may be driven by underlying unconscious processes when it comes to the tale of emotional finance. The psychological dynamics could push investors into deeper cognitive biases and make their love for phantastic objects more intense because bad information and negative emotions are forcibly suppressed, eliminated, or stripped to the unconscious. Investors may think that the phantastic objects they fell in love with were a growth investment but are now value firms with solid operating. So, stocks of the firms can be bet on as value investments despite the prices already high. Unfortunately, good companies and managements do not guarantee future increases in stock price, which is a representativeness bias that behavioural finance scientists warn about.

However, debiasing (Menkhoff and Nikiforow, 2009) may be impossible when people operate the PS state of mind. Instead, psychological dynamics would strengthen the individual bias to a group level. For example, Financial Times editors first compared Snap with Twitter to catch more eyes in readings. Then after Snap’s improvement in management, they suggested this company would be another omnipotent Facebook. Such cover stories with anchoring bias cater to people's unconscious needs for more eyes in readings. They could promote group-level heuristics and biases through the common pursuit of the investors and are common fuels of nowadays overpricing.

This is calling for future policy research on two directions in regulating professionals. Maybe requiring editors and columnists to be Certified Financial Analysts before practising for media that the public trusts and regularly publishing the records that media or professionals disseminate information relevant to cognitive bias is an option. However, this may be a palliative effort that policymakers could combine with root treatment going beyond the individual level biases to make it mandatory for all financial institutions and media to hire a certain percentage of certificated therapists to keep as many investors as possible at the D state of mind.

The outstanding contribution of emotional finance to social science should not be overlooked. It explains market-wide experiences globally by acknowledging and analysing the significant activities driven by unconscious psychodynamics. In contrast, behavioural finance lists a large bag of possible individual biases (Hirshleifer, 2015) that are tough to test and modelled with satisfying ecological validity (e.g., Chan et al., 2004); thus, market activity and group psychodynamics are ignored.

However, there is no journal specialising in emotional finance. Global policymakers should explore the potential to make up more research funding for emotional finance studies as the security of the global financial system is vital for the world. A journal of emotional finance letting relevant research assisted by cutting-edge technology in a more focused, collaborative, and innovative platform is not doubt.

5. Conclusion

Emotional finance is the key to unlocking the stock market bubble puzzle and what policy efforts to help investors in need that policymaker could explore.

Instead of drawing on traditional finance and behaviour finance theory, the report employed a five-stage trajectory appropriating integral unconscious fantasy to unveil the nature of the current market by comparing it with the reviews on the dot.com bubble.

The current stock market mirrors the dot.com mania, which is frothing at the stage of rushing to possess and heralds the manic denial soon. People step into the same river not because of new information or knowledge but because their gambling nature drives them to seek phantastic objects and makes their state of mind operate in PS. They thus are enabled to pursue phantastic objects, which is already risky, to absorb excitement, pleasure, and omnipotence regardless of any warning.

Taking away more general learnings for better market governance, although policies can contribute to investors by learning from behavioural finance, policymakers should consult and invest in emotional finance more if they want to go beyond the individual level to govern the market better.

JIAQI WU, London Business School, is a Sloan Fellow; Warwick Executive MBA with Distinction; MBA Exchange at SDA Bocconi School of Management.