Practical analysis for investment professionals
03 July 2018

The Knowing-Doing Gap in Behavioral Finance

Why do professional investors talk about behavioral finance more than they apply its insights to achieve more rational decision making?

Ambiguity Tolerance Beats Artificial Intelligence” made the case for the ongoing primacy of the human investment decision maker, despite the availability of more advanced decision support systems (DSS). The related conceptual framework helped categorize academic and practical insights on how to embed DSS, like artificial intelligence (AI), in the choice architecture of a professional investment process.

Here we explore a critical phenomenon within this framework, one described in the previous article as follows:

  1. Many still accept the rational agent model and its related theories and methodologies.
  2. Even those who value behavioral finance insights tend only to use them to demonstrate their awareness of cognitive biases, not to apply behavioral finance solutions to improve decision making.
  3. Those who work on behavioral finance solutions often have an outward focus, exploring the sentiment of others — economies, groups of market participants, etc. — through, for instance, sentiment indices, client questionnaires, and cognitive finance.

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These three forms of resistance share the same foundation: Decision makers must adapt their behavior in response to adaptive markets but tend not to.

Though change and change-related challenges are widely researched in the general management literature, they are under-researched in the asset management industry. Nevertheless, the takeaway is clear in all fields: Inducing and manifesting individual and organizational change is exceedingly complex. As Robert Kegan and Lisa Lahey observed, “We all know there is a big gulf between insight and the ability to act upon it.

Analyzing the Why

Why is this phenomenon more pronounced in the asset management industry? To answer this question, we developed two laws based on the academic literature and our efforts working with clients to improve their investment processes.

Panthera Discovery 1

The least resistant way to change a person’s behavior is the one without awareness.

Resistance to change is not a matter of choice but of our cognitive default setting: Our limbic system manages how we think, including how much more rational reasoning influences that process.

The synapses of our cortex area (rationality/consciousness/System 2) can change the structure of their connections, or learn, faster than System 1-related brain areas. But to do so, the cortex must consume more oxygen and sugar, especially during high concentration: Using our consciousness is physically demanding. So our brain by defaults to System 1, with faster and more energy-efficient routines that rely on cognitive shortcuts, or heuristics.

The current standard cognitive neuroscience model divides System 1 into intuition-driven preconsciousness and instinctual unconsciousness. Intuition constitutes our long-term memory, in which all our experiences and reflections are condensed. Adding intuition to our thinking process increases the likelihood of a more rational outcome, but takes more time. Nevertheless, we should avoid including our faster, instinct-driven unconsciousness, or “gut feeling,” in decision making.

The Sludge Factor

“Sludges” are among the most common applications of behavioral insights. These destructive nudges attempt to persuade us to consume products and services that we neither need nor want.

Sludge-Nudge-Heuristic Chart

©Panthera Solutions

Sludges exploit our reliance on intuition- or instinct-driven heuristics. If our short attention span is not guided towards more rational thinking, we subconsciously repeat our routines. System theory and cybernetics call this “autopoiesis,” which refers to a system that can reproduce and maintain itself. Autopoiesis distinguishes between cognition and consciousness since we may not be aware of the foundation on which we make our decisions.

If changes are introduced unconsciously through our limbic system, we may adapt to the new normal without being aware of any change. This occurs naturally when we seek “normality” and establish routines that enable autopoiesis. This “below radar” adaptation can even lead to “unethical amnesia,” wherein we misremember our ethical lapses to protect ourselves from the internal distress that they might evoke. Part of our brain wants to avoid ambiguous and complex situations, whether they are caused by external factors or ourselves.

Empowerment is unnecessary if the goal is to only temporarily change someone’s behavior. Simply arouse the limbic system and our instincts will respond and immediately adapt our behavior. We can even impose change against someone’s will.

But that doesn’t create an empowered decision maker capable of creative and critical thinking, only an assimilated one.

Can we expect lasting behavioral change when such a change is imposed? Probably not. Once the source of arousal fades, so too does the need for an immediate response. Though over time we develop fight-or-flight response patterns that do initiate enduring behavioral changes. This is why sludges still work even when we know better.

Empowering an individual over the long term requires a more conscious form of development. And it starts with storytelling. The only way a person can change is if they change the story they tell themselves about themselves,” James Hillman, the founder of archetypal psychology, observed.

This can be a litmus test to determine if an intervention might increase empowerment. And it turns out, that simple interventions methods like disclosures, traditional education like seminars or keynote speeches, and nudges are all ineffective when it comes to empowering the individual.

Beyond Nudge Empowerment Examples

Source: Greg Davies, Centapse; modified by replacing “knowledge” with “empowerment.”

As a consequence, the standard change model for an individual can be characterized as dysfunctional. It is defined as follows:

A clear goal + a careful action plan + monitoring of our behavior toward that goal + willpower = successful change

The dysfunction is rooted in two unrealistic assumptions:

  1. That we can consistently apply our willpower.
  2. That we can succeed by directly changing our problematic behaviors into desired behaviors.

A more conscious form of development must address both assumptions.

About Willpower

The assumption that self-control is a function of willpower is increasingly tenuous. Self-control and its benefits may not influence limbic-system impulses at all. Instead, recent research culls a few lessons from those people who do exhibit self-control:

  • “Want to” goals are more achievable than “have to” goals: Meaning matters.
  • Structure your life to avoid having to make self-control decisions in the first place by learning better habits: Choice architecture matters.
  • Some people are less prone to temptation because they are conscientious — a personality trait that can also be influenced by genetics: Genetics might matter.

About Direct Change

Hillman’s words help explain why seamlessly switching from a problematic to a desired behavior is impossible. A lasting and more conscious form of change requires rewriting our narrative identity by adapting our mental immune system.

Narrative Identity and Mental Immune System

“Narrative identity” is the unwritten, unspoken, and usually unconscious story that defines who we are, what we do, and why we do it. It operates as a template for our actions. To rewrite our narrative, we have to intervene in our mental immune system, which like our physical immune system, has a self-protective function: to guard us from the psychological trauma and danger that sudden change can bring.

This can also keep us from making positive changes. Our mental immune system is often rooted in unexamined beliefs. Therefore, rewriting our narrative begins with instilling a more conscious set of beliefs.

Personal change goals can be adaptive, according to Ronald Heifetz’s distinction between “technical” and “adaptive” challenges. These require a shift in mindset, not just behavior.

Framework for Change

Empowerment is central to creating a framework for change based on the science of the brain. Empowerment requires that we redirect our attention to change how the brain functions. This is what the literature calls neuroplasticity. When we consciously shift our attention, we help facilitate self-directed neuroplasticity.

Popularity: A Bridge between Classical and Behavioral Finance


To empower more rational decision making, we should avoid sludges in favor of choice architecture-embedded nudges and intuition-driven heuristics. Aligned choice architecture minimizes the need for willpower.

Reflecting on our heuristics-driven narrative function is key element of the choice architecture to support desired behavior, as it can minimize the prohibiting effects of contradicting beliefs that compose our mental immune system.

Panthera Discovery 2

The less personal the variable to be optimized in an investment process, the lower the resistance. 

We found that when optimizing an investment process, the degree of organizational resistance to change depends on the optimization goal. Minimizing fees, re-allocating to exchange-traded funds (ETFs), and re-negotiating transaction fees with brokers tend not to trigger much resistance. As a general rule, professional investors acknowledge the advantages and follow the recommendations. They are equally willing to optimize tax structures or implement regulatory changes.

Resistance to Change in Asset Allocation-Type Decisions

©Panthera Solutions

The diagram above shows how increased organizational resistance can relate to asset allocation-related topics. With respect to subject-specific input on methodologies, resistance is low where professional investors are academically or professionally socialized and increases as this input moves beyond their academic or professional socialization.

For example, a CIO trained in modern portfolio theory (MPT) who applies the mean-variance optimization, will likely offer little resistance to a proposal to use minimum-variance optimization. That same CIO will likely be much more resistant if asked to switch from correlation-based risk management to causality-based risk management.

Resistance usually peaks when the investment process variable relates directly to the individual, such as when it involves optimizing a daily work routine, configuring the team roles, or reducing the knowing-doing gap

Starting Points for Interventions

The change management literature approaches changing the individual through interventions from a cultural or technological perspective.

Common Starting Points in Change Management Literature

©Panthera Solutions

Cultural change is the result of individual behavior, not its starting point. Starting with technological change emphasizes assimilation not adaptation.

In a relatively static environment, with traditional forms of leadership — autocratic style, hierarchical top-down delegation, non-inclusive choice architecture — technological change could lead to behavioral change but not to empowerment. It doesn’t pass the test of what Heinz von Förster calls the ethical imperative: “I always act so as to increase the number of choices.”

Both the cultural and technological angles are invalid starting points to induce lasting change because they don’t target the individuals’ response elasticity. Both try to invert the cause-effect logic in change management, trying to avoid the most challenging and thus the most yielding trigger for change: the individual.

Empowerment creates more adaptable individuals and, as a consequence, more adaptable organizational behavior. Tolerance of ambiguity and complexity helps create a more reflexive set of heuristics through which an individual perceives the world. Thus, when the world changes, heuristics can be adapted, whether they are replaced, reweighted, or complemented by new heuristics that are added to the individual’s adaptive toolbox. The toolbox itself provides a framework for non-optimizing visions of bounded rationality, emphasizing psychological plausibility, domain specificity and ecological rationality.

Most Effective Starting Point in Change Management: Individual Change

©Panthera Solutions

To empower individuals, emphasizing leadership traits is ineffective. The field of leadership development has overfocused on leadership and underfocused on development. Libraries are full of literature exploring the most important leadership traits and how to acquire them. But without a better understanding of human development, one that applies to all members of an organization, leadership development is just leadership learning or training.

Both represent superficial perspectives. Empowerment enables the individual to a more fundamental adaptation in making meaning. Cognitive neuroscience research shows that the adult development dimension in organizational learning theory represents the key success factor and that qualitative changes in our mental equipment after adolescence are achievable.

John Kotter of Harvard Business School summed these concepts up well:

The central issue is never strategy, structure, culture, or systems. The core of the matter is always about changing the behavior of people.


Organizational resistance increases the more personal the matter. If lasting change is the goal, start by empowering the individual, thereby making it personal.

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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/FrankRamspott

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About the Author(s)
Markus Schuller

Markus Schuller is the founder and managing partner of Panthera Solutions. As a leading behavioral design company, Panthera optimally configures the investment decision design of professional investment processes to facilitate most evidence-based decision making. As adjunct professor, Schuller teaches such courses as Adaptive Risk Management, Investment Banking, and Asset Allocation for Practitioners at the renowned Master in Finance programs of the EDHEC Business School and the International University of Monaco. Schuller publishes in top academic journals, writes articles for professional journals, and delivers keynotes at international investment conferences. In short, as investment banker, adjunct professor, and author, Schuller looks back at 20 rewarding years of trading, structuring, and managing standard and alternative investment products. Prior to founding Panthera Solutions, he worked in executive roles for a long/short equity hedge fund for which he developed the trading algorithm. Schuller started his career working as an equity trader, derivatives trader, and macro analyst for different banks.

2 thoughts on “The Knowing-Doing Gap in Behavioral Finance”

  1. Dougal Williams says:

    Very interesting!

  2. Antonio says:

    Great approach, very interesting article.

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