Practical analysis for investment professionals
17 September 2014

Have the Behaviorists Gone Too Far?

In 1966, Abraham Maslow published The Psychology of Science: A Reconnaissance. Building on a concept he had touched upon in earlier works, Maslow wrote, “I suppose it is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail.” It was a clever way to discuss confirmation bias, and the phenomenon he described became commonly known as Maslow’s hammer or man-with-a-hammer syndrome.

Of course, Maslow’s quip was not intended for tradesmen working in the physical world. No, instead this remark was referring to people working with ideas — psychologists, politicians, teachers, business leaders, and, of course, analysts, portfolio managers, and investors. It is much easier to imagine a person working in a knowledge-based trade applying a framework that he or she believes in only to discover that the world around them is more complex than expected.

Subscribe Button

Imagine an analyst who believes a particular management team is effective because it has met or exceeded EPS guidance for 16 consecutive quarters. How surprised and disappointed this analyst would then be if the company’s stock crashes when it is revealed they only met or exceeded EPS guidance by ramping up low-quality loans in off-balance sheet vehicles! Of course, this is only one of countless examples in which our perspective, and even our expertise, can fail us. In analysis, it is much easier to shove square pegs through round holes than it is in the physical world.

Behavioral finance practitioners and academics alike agree that human beings are flawed, which, of course, we are. We can and do make poor choices, particularly when faced with uncertainty. Of course, what is more uncertain than the markets? So, investing is rife with examples of irrational behavior. Pioneers in behavioral finance, such as Daniel Kahneman, often present compelling examples of how people make poor choices in situations in which there are demonstrably superior alternatives. From myopic loss aversion, to social proof, to thinking fast, the list goes on and on. I’m a big believer in all of this and have used a variety of behavioral models as an analyst and fund manager.

Nevertheless, I have recently begun to wonder: Have the behaviorists’ claims gone too far?

If you listen to many behaviorists present their case, one might conclude that every decision we humans make is bad. For instance, Kahneman recently said:

“The idea of self-defeating behaviour, of fate working through the actions of individuals to ultimately destroy themselves — that is a major theme. We put an inordinate weight on minor embarrassment relative to significant consequences. I would imagine that many people have died in house fires because they were looking for their trousers.”

House ad for Behavioral Finance: The Second Generation

How can this be? Are we all so very shortsighted? Aren’t we as individuals capable of learning from our mistakes? How many times must we put our hand on a hot stove? In our everyday experience, we don’t find the haphazard, unpredictable world that many behaviorists would have us believe in. There is order amid the chaos, isn’t there? This is why German psychologist Gerd Gigerenzer released a new book titled Risk Savvy: How to Make Good Decisions in which he tries to debunk much of Kahneman’s work. In his own words, Gigerenzer believes Kahneman takes an unfairly negative view of the human mind.

Applying the behaviorists’ ethos to finance, it seems every investment we make is bad. How is this possible when there are two people on opposing sides of every trade? One person is selling when another is buying. So, isn’t one person wrong and the other one right? Doesn’t it follow that one of the two made a good decision — even if for the wrong reasons?

The world is more complicated, you say? I agree. But different people have different objectives, time horizons, risk tolerance levels, constraints, emotional and psychological profiles, etc. In short, they have different investment policies. An investment policy statement is a document which spells out how a given portfolio is to be managed against a wide range of factors important to the owner of the money. Even if investors don’t codify it in an investment policy statement, every investor has some set of investment policies, however well or poorly defined. Yet, none of the behavioral studies I’ve seen measure an investor’s actual choices relative to that investor’s investment policy. I know this because investment policy statements, where they exist, are not public. They are very personal documents that are held very closely.

Financial Analysts Journal Current Issue Tile

The only thing we do have that gives an indication of public investment policies are mutual fund prospectuses. Even here, mutual funds are replete with agency costs both within the firm and with outside “interested parties” that sometimes dictate the investment choices of portfolio managers. How can this possibly be captured in a database of mutual fund manager performance? I know of many fund managers who were forced to abandon their own investment principles to satisfy irate bosses or outside consultants in the interest of short-term performance. In many cases, fund flows determine how and what investors can buy. When faced with the choice to stick with their investment philosophy or placate the whims of their fee-paying clients, many fund companies choose the latter. The ethical implications of such choices are certainly fraught and worthy of discussion in their own right; all I seek to highlight here is that the data is not so clinical and objective as to lend itself to simple analysis.

We live in a world of constant uncertainty. A stock price going up after you sell the stock, or a bond price going down after you buy the bond, tells you nothing about whether or not these were appropriate choices given an investor’s policy. Taken to its extreme, should investors be upset with themselves if they didn’t guess the right lottery numbers last week? Yet, behaviorists apply their research to investing, which must grapple with investors having dramatically different investment policies and, of course, must deal in a world of uncertain outcomes. Are they applying their interesting results out of sample?

Moreover, behaviorists tend to apply their framework to financial decision making among individuals. However, these same individuals must deal with uncertainty about agency costs in policy. How much money will the Fed print? Will Japan max out its ability to sell government bonds? Will the US Environmental Protection Agency shut down coal-fired power plants? Can the euro survive another recession? What impact will robots have? Will new sites like Kickstarter promote greater productivity growth as barriers to capital are eroded? So many questions, so few answers.

Tile for Future of Work in Investment Management: 2021 Report

Given that we have so few concrete answers, can we call any investment behavior irrational? As my colleague Jason Voss, CFA, likes to say, data and analysis capture the past and maybe the present, but investment results unfold in the future. Likewise, investor knowledge is shaped by the past but cannot possibly encompass the future. It seems that many have picked up the behaviorists hammer and now at least to them, everything looks like a nail.

If you liked this post, don’t forget to subscribe to the Enterprising Investor.

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/ Luciano_Queiroz

Professional Learning for CFA Institute Members

CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker.

About the Author(s)
Ron Rimkus, CFA

Ron Rimkus, CFA, was Director of Economics & Alternative Assets at CFA Institute, where he wrote about economics, monetary policy, currencies, global macro, behavioral finance, fixed income and alternative investments, such as gold and bitcoin (among other things). Previously, he served as SVP and Director of Large-cap Equity Products for BB&T Asset Management, where he led a team of research analysts, 300 regional portfolio managers, client service specialists, and marketing staff. He also served as a Senior Vice President and Lead Portfolio Manager of large-cap equity products at Mesirow Financial. Rimkus earned a BA degree in economics from Brown University and his MBA from the Anderson School of Management at UCLA. Topical Expertise: Alternative Investments · Economics

5 thoughts on “Have the Behaviorists Gone Too Far?”

  1. Newell White says:

    A class of mistakes not covered by behaviourists, but relevant to investment decisions, is the mistake-as-self-expression.
    I acknowledge I make mistakes, and try to avoid repeating them. I observe a large number of people who are reluctant to admit to mistakes, and seem to make variations of a particular mistake repeatedly. My guess is that this behaviour is driven by a need to express a repressed subconscious urge.

    Disclaimer: I am not a dyed-in-the-wool Freudian, or any other such school!

  2. Newell, thank you very much from your comment. I have seen that same phenomenon at work in the investment industry all too often. I hope I haven’t committed it myself. I think that sometimes the reticence about admitting mistakes is because the mistake conflicts with some deeply held beliefs. Admitting to the mistake might also mean admitting their deep-seated belief is wrong. (For example, a value investor might not recognize a value trap even after sufficient evidence piles up.) And at other times, it conflicts with the ego whereby people choose conclusions that are comforting to their self-image or protect their self-worth as “smart” or “accomplished” or “capable”, etc.

  3. Michael Falk says:


    According to Wikipedia, “It is believed by some philosophers (notably A. C. Grayling) that a good rationale must be independent of emotions, personal feelings or any kind of instincts. Any process of evaluation or analysis, that may be called rational, is expected to be highly objective, logical and “mechanical”. If these minimum requirements are not satisfied i.e. if a person has been, even slightly, influenced by personal emotions, feelings, instincts or culturally specific, moral codes and norms, then the analysis may be termed irrational, due to the injection of subjective bias.”

    So… decisions cannot be made rationally since context matters and above all the neuroscience research implies that we cannot make decisions without our emotions. Montier refers to this as the “human condition.” I like to say that we are neither rationale nor irrational, but simply human.


    1. Michael, Thanks for your comments! While I like your approach, remember you don’t have to extract every bit of emotion from your decisions, just the one’s that lead us astray. There are techniques for dealing with this. I’ll be writing a lot more on this topic in future. Thanks for participating!!!!

Leave a Reply

Your email address will not be published. Required fields are marked *

By continuing to use the site, you agree to the use of cookies. more information

The cookie settings on this website are set to "allow cookies" to give you the best browsing experience possible. If you continue to use this website without changing your cookie settings or you click "Accept" below then you are consenting to this.