The Knowing-Doing Gap in Behavioral Finance

“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.

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.