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.Tangentially related:
Of course, Maslow’s quip was not intended for tradesmen working in the physical world. No, instead this remark was referred 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.
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.”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....MORE
Book Review: "Cass Sunstein’s Latest Combines Banal Insight with Pernicious Intent"
Not seeing Sunstein as an intellectual heavyweight has actually gotten me banned from some polite company but even with that social ostracism I still think he's just a busybody.
So it was with great delight I read the first line of this review and decided to use it as a headline.
From Spiked:
Cass Sunstein’s Latest Combines Banal Insight with Pernicious Intent
Social scientists sometimes have an irritating habit of devoting a lot of resources and time to the rediscovery of the blindingly obvious. It is in this vein that Cass R Sunstein’s Why Nudge? boasts of the brilliant insights of behavioural economists who have ‘discovered’ that people often take decisions about their life that contradict their individual interests or aims. Throughout Why Nudge?, this unremarkable insight – well known to most mature adults – is presented as an amazing game-changing discovery.
The reader is constantly reminded that ‘behavioural findings’ show that ‘people make a lot of mistakes, some of which can prove extremely damaging’. People are sometimes short-sighted and, apparently, ‘procrastination, inertia, hyperbolic discounting and associated problems of self-control’ create all kinds of adverse outcomes for people. We are also informed that human beings make erroneous choices which ‘fail to promote their own ends’. Sunstein appears to revel in highlighting the different manifestations of the ‘human propensity to err’. He characterises what were formerly perceived as human weaknesses and poor choices as behavioural market failures. The purpose of this term is to draw an analogy with the economic concept of market failure.....MORE
