Irrationalities in Traditional Finance: 4 Lessons from Financial (Mis)Behavior

We hope our financial systems accommodate rational people. However, at nearly every point in the chain, irrational actors are involved. Our financial system full of human error, possible corruption, bias, and arrogance, sometimes “on purpose” and sometimes “on accident.” I attempt to explore how behavioral and cognitive psychological theories with conventional economics and finance provide explanations for irrational behaviors within finance.

Powerful professional cultures like financial services, maintain an unshakable faith in their often irrational structures of risk taking, compensations, and decision making since it is sustained by a community of like-minded believers (Kahneman, 2011). Given the professional culture of the financial community, it is not surprising that large numbers of individuals in financial services believe themselves to be special few who can do what they believe others cannot. Or as Nobel prize winning financial economist Robert J. Shiller in his bestseller Finance and The Good Society mentions, finance is “pursued as a calling — a noble call to duty”. The “know it all” illusion is not only an individual flaw; it is deeply ingrained in the culture of the financial services industry.

When we want to understand why financial investors make seemingly irrational financial choices, odds are we will find answers in the research of Nobel-winning behavioral economist Daniel Kahneman. But guiding investors toward a better financial future is only one-way to apply behavioral finance. Kahneman says we solve virtually all problems, not just financial ones, with two distinct types of thinking — System 1 and System 2.

“System 1" is fast, instinctive and emotional; “System 2” is slower, more deliberative, and more logical. Illustration by David Plunkert

System 1 (Thinking Fast) is unconscious, intuitive and effort-free. System 2 (Thinking Slow) is conscious, uses deductive reasoning and is an awful lot of work. System 2 likes to think it is in charge but it’s really the irrepressible System 1 that runs the show. There is simply too much going on in our lives for System 2 to analyze everything. System 2 has to pick its moments with care; it is “lazy” out of necessity.

Thinking, Fast and Slow, was a 2011 bestseller because it challenged rational assumptions of conventional finance. In his book, Kahneman elegantly combined cognitive theory with conventional economics. He summarized his lifetime of work on how the mind works, covering many topics familiar to those who follow behavioral economics and finance. Specifically discussed in this article are Kahneman’s arguments on decision-making, heuristics, illusions, risk, overconfidence, and incentives in conventional financial structures. The mentioned arguments allude to loopholes in conventional financial theories that impact investing seeks close.

For a while, theoretical and empirical evidence suggested that Capital Asset Pricing Model (CAPM), Efficient Market Hypothesis (EMH) and other rational financial theories did a respectable job of predicting and explaining certain events. However, as time went on, academics, like Kahneman, in both finance and economics have started to find anomalies and behaviors that couldn’t be explained by theories available at the time. While these theories could explain certain “idealized” events, the real world proved to be a very messy place in which market participants often behaved very unpredictably. A sustainable approach that impact investing presents to offset irrationalities in conventional finance.

Lesson #1 
Illusions of Understanding in Finance: Know your facts

Don’t be sheep. Fact-check conventional wisdom.

The illusion of skill is quite pervasive in the culture of the financial services.

For instance, the global financial crisis that broke out following the collapse of Lehman Brothers in September 2008 came as a big shock. It’s an example of irrationalities in conventional finance that cannot be overlooked. Before September 2008, the prevailing consensus among officials and specialists was that financial innovation was a good thing. In isolated instances, a particular new product might not work out as planned, as happens, for example, with medical innovation.

But over all, the consensus went, financial innovation led by the private sector was making the system safer and more efficient. This view, as we came to know, was wrong. Kahneman’s argument on availability of heuristics and illusions of understanding explain why this arguably incorrect point of view that eventually lead to the 2008 financial crisis was so widely accepted.

Kahneman defines availability heuristic as, “the process of judging frequency by ‘the ease with which instances come to mind”. This means the brain creates mental shortcuts to come up with answers for things, but it requires the ability to quickly think of specific examples. It’s important to keep in mind that these mental shortcuts inevitably contain bias. This is due to the fact that these mental shortcuts require specific examples, and often these examples skew people’s view of how important or how often these events really happen.

Biases factor into illusions of understanding, when people often tell stories about the past with the belief that they have a full understanding of what happened. When it comes to storytelling, it’s much easier to create a coherent one when a person knows less about the topic or situation. The reason behind this is simply that there is less information to try to fit into the story, so it comes out as a simple and more straightforward story.

Applying heuristic biases and illusions of understanding, in the context of financial services, before the 2008 financial crisis — the simple line of narrative that deregulating financial services would benefit the economy, created biased perspective amongst financial advisors, regulators, and government officials. This bias justified the legal and regulatory changes that allowed some banks to become very large and to build up a much more complex range of activities in the 1990s and early 2000s, including through various kinds of opaque derivatives transactions. In retrospect, much of the financial innovation in the previous decades built up risk for the financial system in ways that were not properly understood by regulators or, arguably, by management at some of the largest banks.

In spite of the wakeup call in 2008, there has been little revision to inefficient financial structures. Impediments in revising financial structures to make them safer, post financials crisis, could also be explained with heuristics. After every decision is made, a person is able to look back at the choices and decide whether they were good or bad. This ability to look back on choices in referred to as ‘hindsight bias’. Although hindsight bias seems as if it could provide more insight on the decision making process, it doesn’t. Hindsight bias generally has people look more at what the outcome of a situation was, rather than how the decisions were made to lead to that outcome.

Kahneman also mentions that the worse a consequence is, the better the hindsight tends to be. Hindsight bias in post the 2008 financial crisis, clearly demonstrates the illusion of understanding things by allowing a person to look for answers in the wrong part of a situation, which is why the process of reforming the financial system is still at a slow and early stage. The Dodd-Frank financial reforms of 2010 represent a useful start — including the Volcker Rule‘s restrictions on excessive risk-taking — and the recently adopted Basel III framework for capital regulation nudges higher equity requirements.

As The Impact Investor: Lessons in Leadership and Strategy for Collaborative Capitalism suggests, impact investing has challenged biases and illusions in conventional finance that maintain the interests of capital and impact are incompatible. Financial investors hyper-fixated on financial performance, without the consideration of impact, will be financially and socially unsustainable.

Lesson #2
Risk Taking Financial Behavior: Don’t make impulsive decisions

The availability heuristic is related to emotions and risks that are applicable to financial behavior.

Kahneman discusses the factor of wealth in risk taking. He provides several hypothetical scenarios that involve money and explains why a person would pick a certain choice. For one thing, he found that people were more willing to take chances on things that had a certain guaranteed outcome. The other reason was people were more like to base a decision off of how much it was going to change their wealth.

Several experiments by Kahneman illustrate that investors and financial advisors with fee-based structures make risky investments destroy social and financial capital, in hopes of expecting a higher financial return. Robert Shiller also argues that excessive risk takers and the respect they socially receive has exasperated tolerance for social inequality (2013).

Risk seeking behaviorally varies according to preference (Shiller, 2013). Kahneman’s ‘expected utility theory’ explains the difference in an investor’s risk appetite (2011). The theory was the idea that if a person was presented with an equal chance of winning two different objects, they would be more inclined to try to win the object that they prefer. The reason behind that would simply be personal preference. Shiller explains that risk appetite is higher in individuals whose dopamine neurons need to be stimulated more often. Sensation seeking appears to reflect physical properties of the brain, something that cannot changed, which perhaps make a case for regulating financial industry to offset irrational investor behavior (2013).

Apart from regulation, adopting impact investing’s approach could mitigate risks-seeking behavior by irrational investors. As traditional financial analyses is not a screening process but a research process and sustainability issues can materially impact a company’s ability to sustain both earnings and a long-term competitive advantage. (Clark, Emerson, Thornley, Ben, 2014)

Lesson #3 
Overconfidence in Financial Behavior: Intuition does not triumph due diligence

Investors who exhibit risk seeking behavior are also more likely to be overconfident about their assumptions. Investors who evaluate their expectations are prone both to overestimate their chances and estimates (Kahneman 2011).

Even experienced professionals get probability and uncertainty terribly wrong, usually leading to overconfidence and mistaken decisions. In one experiment, chief financial officers of corporations were asked to forecast the return on the Standard & Poor’s index over the following year, giving one number they were 90% sure was too high and another they were 90% sure was too low. The true number was outside their intervals 67% of the time. (Kahneman, 2011)

Shiller seconds Kahneman, and explains overconfidence is the dominant reason for trade in financial markets and ego involvement judgments are antithetical to the Efficient Market Hypothesis. (2013). These overconfident misjudgments could be mitigated through impact investing where extensive due diligence triumphs impulsive buying or selling. Thereby, offsetting irrational financial behavior.

Lesson #4
Misguided Incentives in Financial Services: Do not tie compensation to lucky outcomes

One must wonder why expert financial advisors are paid handsomely, even when they’re likely to suffer from misjudgments due to heuristics and illusions of understanding. Surprisingly to some, Kahneman found financial advisors were paid for lucky outcomes, not for their skills. Firms however, as Kahneman found, rewarded luck as it were a skill and were hesitant to accept that they were being compensated on their luck not skill as it clashed with their personal impressions of being skilled professionals who were compensated for their talent, not luck (2011).

Financial institutions resisting changing their irrational structures that place hefty compensations based on luck, has factored into income inequality, as mother of socially responsible investing Marjorie Kelly mentions. Since incentives are not rationally tied to skills, the proportion of employees making poverty-level wages has climbed substantially (Kelly, 2001).

According to The Global Impact Investing Network Brief Issue (2011), to avoid conflict of incentives, fund managers in impact investing could have their incentives tied to achieving social and/or environmental impact in addition to generating financial returns.

Rethinking Conventional Finance

Kahneman’s endorsement of “libertarian paternalism” towards the end of the book contains many good ideas for regulations, nudging people in the right direction, such as default savings plans or organ donations. Especially since, as Shiller mentioned, human risk taking tendencies could be biologically hardwired and unchangeable therefore need regulatory controls. Some might argue Kahneman and Shiller’s suggestions are too sweeping, although their recommendations are reasonably founded in empirical evidence and years of research on irrationality.

Irrational behavioral finance also makes a strong case for impact investing where irrationalities are offset by consideration for social capital, careful due diligence, and sustainable incentive structures.

Instead of how we should rationally behave, wouldn’t economics or finance make a lot more sense if it were based on how people actually behave?


References

Bouri, A., Lankester, K., Leung, G., Meyer, M., Pease, M., Ragin, L., Schmidlapp, C., & Shah, S. (2011, December). Global Impact Investing Network Issue Brief: Impact-Based Incentive Structures. Retrieved from http://www.thegiin.org/assets/documents/pub/impact-based-incentive-structures-aligning-fund-manager-comp.pdf

Clark, C., Emerson, J., & Thornley, B. (2014). The Impact Investor Lessons in Leadership and Strategy for Collaborative Capitalism. Somerset, MA: Wiley.

Kahneman, D. (2011). Thinking, fast and slow. New York, NY: Farrar, Straus and Giroux.

Kelly, M. (2001). The Divine Right Of Capital. San Francisco, CA: Berrett-Koehler.

Shiller, R. (2012). Finance and The Good Society. Princeton, NJ: Princeton University Press.