This article is adapted from “Intuitive Behavioral Design: How to Empower Professional Investors,” by Dr. Markus Schuller, Shabnam Mousavi, PhD, and Gregory Gadzinski, PhD, from The Behavioral Economics Guide 2019.
“We all know there is a big gulf between insight and the ability to act upon it.” — Robert Kegan and Lisa Laskow Lahey
Specialize or face extinction.
This is the binary choice facing small-to-medium-sized asset managers, which by now include all with under $1 trillion in assets under management (AUM).
Why? Because the asset management industry has become a Xerox machine spitting out standardized, streamlined me-too products. This state of play favors the larger managers above all, and their leverage is further strengthened by digitalization and fee pressure.
Firms that lack benefits of scale must differentiate themselves through specialization.
This pathway begins with understanding behavior — of other market participants as well as our own.
It means burying homo economicus once and for all.
Ample scholarship from Adam Smith and David Hume to John Maynard Keynes and Friedrich Hayek demonstrates that people are not purely rational agents who abide by reason and logic and are molded as homo economicus. Nevertheless, the first two generations of asset allocation models held on to the ideal of homo economicus, and the process of transitioning to third-generation models that apply behavioral insights has been slow and fitful.
Andrew Lo of MIT established the conceptual framework for third-generation models through his Adaptive Markets Hypothesis (ADH) back in 2004. Lo combined evolutionary theory with cognitive neuroscience, theorizing that market participants seek to optimize their satisfaction and are motivated variously by greed and fear.
Concept of Humankind as a Market Participant
Asset Allocation Generations
AMH provides a platform for applying behavioral finance to market analyses.
The implementation of behavioral approaches that undermine modern capital market theory’s already shaky foundations is slow in coming.
And today, a decade and a half later, professional investment decisions makers still tend to talk more about an eventual behavioral influence on their decisions than to actually apply practical behavioral insights.
That’s where our emergent blueprint for directing management changes in asset management comes in. Presented in The Behavioral Economics Guide 2019, this consists of a clarified intervention objective, an intervention and application toolbox, and an implementation roadmap that applies the toolbox.
We call the resulting outcome Intuitive Behavioral Design (IBD).
Our interventions are designed to empower professional investors by facilitating the most evidence-based investment decisions (EBIDs).
Starting this process requires a workable definition of rationality, which we build on the following concepts: An investment decision becomes more rational if (1) the limbic system is stimulated as such to maximize the contribution of the Prefrontal (PFC) and Orbitofrontal Cortex (OFC) to the decision-making process and if (2) PFC+OFC are trained to equip the individual with relevant expert knowledge and related tools to assess the consequences of its use.
Building on this research and applying scholarship to the levels and drivers of consciousness as well as how the mind integrates different cognitive perspectives, IBD brings together the three schools of thought in behavioral finance — Fast and Frugal Heuristics (FFH), Heuristics and Biases (H&B), and Naturalistic Decision Making (NDM) — to develop an understanding of what their respective insights can offer practitioners.
Schools of Thought in Behavioral Finance
Much of the divergence among these schools emanates from their respective take on the nature of heuristics, that is the simple strategies we apply to make judgments and decisions, and on System 1 and System 2 thinking. Are heuristics generally helpful or harmful when applied to decision making in business and finance?
In the early days of behavioral finance, scholarship coming from the H&B school suggested that rational decisions could not be made via heuristics. But Gerd Gigerenzer and other FFH adherents made the case that in the right context, when they were truly intuition based, heuristics could actually improve decision making. Gary Klein’s NDM school bridged the gap between H&B and FFM by differentiating among intuitions that arise through experience and manifest skill (NDM) and those that sprang from simple heuristics.
Intuition- vs. Instinct-Driven Heuristics
The scholarship that aligns with research from evolutionary psychology offers some compelling takeaways: System 1 thinking can be driven by either intuition- or instinct-based heuristics; intuition-driven heuristics should be included in most EBIDS amid uncertainty, while instinct-driven ones should be excluded.
Given this knowledge, why does the rational agent model still persist in finance? Why has the industry lagged in its adoption of behavioral finance solutions?
For one, many still consider the rational agent model and corresponding theories and methodologies the state of the art.
And adaptation is hard. For an individual decision maker, restructuring one’s choice architecture is challenging at best. Renovating choice architecture at the firm level is yet a much taller order. Hence, such processes tend to be regularly procrastinated.
Resistance to Change as Default Setting
How can this resistance to change be overcome?
To address this resistance to change, we designed the Panthera Solution for directed change. It closes the knowing–doing gap by honing in on two key elements:
- An intervention framework that establishes focus to prepare for making most EBIDs
- An application framework that applies the established focus to choose the right tools/methods/sources to make the most EBIDs
The goal is to empower individual decision makers by providing them a choice architecture that fosters that empowerment.
Adaptation is the key to survival in evolutionary biology and today in the investment management field. The old models have become obsolete. New ones that harness the insights of behavioral finance must be embraced. Intuitive Behavioral Design is an important step forward in this direction.
For more on Intuitive Behavioral Design, check out the original article, “Intuitive Behavioral Design: How to Empower Professional Investors,” by Dr. Markus Schuller, Shabnam Mousavi, PhD, and Gregory Gadzinski, Phd, from The Behavioral Economics Guide 2019.
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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.
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