A Theory of Behavioral Finance – Assumption 3 – The Psychological Factors

Several weeks ago I authored A Theory of Behavioral Finance, which was a high-level presentation of the Theory. I promised to cover each assumption more in-depth. This week I describe in greater detail the Psychological Factors that contribute to behavioral biases. In that original piece I said these factors included:

  1. Psychological secondary factors affecting human behavior include:
    1. Behaviors and habits formed based on:
      1. Goals/needs being attained, but relative to energy conservation; needs include:
        • Physiological needs
        • Safety needs
        • Belongingness and love
        • Esteem
        • Self-actualization
      2. Decisions driven by a desire that the benefits of outcomes exceed their costs, including energy and time conservation
  • Positive feedback for courses of action from the environment, the self, and/or from others
  1. When behaviors and habits are automatic, they become energy efficient
  2. Behaviors and habits are typically learned and formed at a young age when self-awareness and self-determination are lower
  3. New behaviors and habits require an initial energy investment to develop strong neural pathways and are energy inefficient

 

How Habits and Behaviors Form

In my last piece in discussing The Biological Factors that contribute to behavior and resultant biases I made use of a model proposed by neuroscientists. It was composed of three components:

 

  1. (P)erceptive: information provided through either the senses of metacognition
  2. (C)entral processing: the brain sorts the stimuli from the Perceptive stage and if familiar it invokes a habit, and if unfamiliar it triggers more deliberation
  3. (M)otor: a decision is made and a course of action taken that triggers a physical, hormonal response that reinforces or dissuades the same course of action being taken again depending on the quality of the outcome

 

Other researchers refer to this sequence as a “cortico-basal ganglia loop.”[1] While still other researchers refer to this same brain functionality as a “habit loop.”[2] Only the nomenclature is different with these different versions of the model, with the three components being: a cue, a routine, and a reward.

Once executed, the outcome of the above PCM model is the creation of a cause and effect chain that directly associates stimuli (the causes) with actions (the effects). When the outcome of executing this chain is positive then this is reinforced with hormones that really, really make us feel good. This, in turn, biases us to execute this routine the next time, too. If this routine is done enough then it creates a habit.

The reason that some researchers call this the “cortico-basal ganglia loop” is that the basal ganglia is directly implicated in the creation of, storage of, and execution of habits. In fact, people with damaged basal ganglia often become mentally paralyzed.

Shockingly, our outward behaviors are usually the net result of a large number of habits operating unconsciously rather than the result of conscious choice. This is called “chunking” by the researchers that refer to the sequence of mental events as a “loop.”

Psychologically speaking, what directs our decision-making in the first place? I think you will agree with me that it is not just energy and time conservation. In short, it is our motivation. Yes, if we are hungry, we develop habits and behaviors – habit loops – associated with our need for energy. But we also develop habits and behaviors affiliated with hundreds of possible stimuli, such as: relieving our boredom, tackling math problems, relating well to our coworkers, finding mates, learning, and so on. Thus, to understand behavioral bias more fully then we need to understand psychology and motivations.

Researchers interested in psychology throughout time have theorized about motivation.[3] I am largely indifferent about which theory is superior to the others. Instead, I find value in each of the major theories of motivation. Among those you may have heard of are:[4][5]

 

  • Herzberg’s Two-Factor Theory
  • Maslow’s Hierarchy of Needs
  • Thorndike’s Law of Effect
  • Hull’s Formalized Drive
  • Skinner’s Operant Conditioning

 

As an example of possible motivations for actions let us look at Maslow’s Hierarchy of Needs. He specifically theorized that there were five basic needs/motivations:

 

  1. Physiological needs, such as finding food, reproduction, and sleep
  2. Safety needs, such as shelter, homeostasis, access to capital, and absence of violence
  3. Belongingness and love, such as groups and people that create affiliation
  4. Esteem and achievement, such as recognition for our contribution to the collective
  5. Self-actualization, such as achieving our full potential or enlightenment

 

Maslow also believed that people focus at fulfilling their initial needs before evolving to those higher up the hierarchy. This part of his theory has largely been debunked. Researchers have found, for example, that the boundaries between the hierarchy needs are blurred, and that people have varying degrees of the hierarchy in place and not sequentially. In fact, many self-actualization traditions hold that the most evolved should take vows of poverty and shun all but the most basic material concerns, and that a sense of self-esteem and achievement is counter-productive to development.

Nonetheless, I like Maslow’s framework because it shows the different categories of psychological motivations. Further, it creates distinctions between biological, psychological, and sociological factors. Each of these are recognized as causes for behaviors and habits.

 

Habits and Behaviors Conserve

One of the reasons habits and behaviors are difficult to change is that once they are formed, the brain regions needed to execute an action are reduced. Additionally, the amount of energy needed to come up with a reaction to a familiar pattern is also reduced. Just as I related in my last piece on the biology of behavior, habits form because the brain is looking to conserve energy. Dunhigg says in his The Power of Habit, “When a habit emerges, the brain stops fully participating in decision making.” Ouch.

But we do not just conserve energy and time in service to our biology. We also conserve our self-esteem and relationships which is why we are more tolerant of those with whom we have strong bonds, than those we have just met. Furthermore, and in rough accord with Maslow’s Hierarchy of Needs once a person has established physical, mental, and spiritual health in accord with their motivations then they tend to live their lives strongly in accord with the habits that led to these preferred outcomes. Why?

Because these desired outcomes are reinforced hormonally and they feel very good. Said another way, our habits ask of us “if it ain’t broke, why fix it?” The answer, of course, is that our behaviors and habits may not be the very best ones available to us. In short, due to conservation, most of us are content with our behaviors, even if upgrades are available. Consequently, most of us are walking around with outdated and unexamined behaviors that were minted many years in the past.

 

Behaviors and Habits Largely Form in Youth

Once the umbilical cord is cut between us and our mothers, satisfying our own needs becomes front and center in our motivations. At that moment of emergence into the world, the mechanism of the PCM model also kicks into gear. We begin perceiving things, and slowly over many years, reacting and responding to them. Each time the outcome of our decisions is a good one, that decision is positively reinforced chemically.

In time, if that “chunk” delivers positive outcomes with high probability then it becomes a habit loop. Last, it has as an unwanted side effect the creation of unawareness around our habits and behaviors. The reason, of course, is conservation.

Thus, long before we arrive at the moment when we need to respond thoughtfully (i.e. avoid loss aversion bias) to a massive decline in the price of one of our investments, we have an entire lifetime of habits developed out of domain, and out of time with a real time event. In this circumstance, we stand a very low chance of breaking old habits. Whoa!

Psychologists that study habit formation have long recognized that most of our habits and behaviors are near permanently minted when we are children. For example, a recent gigantic study of 50,000 families found that most of our key behaviors and habits are in place by age 9.[6] These included things like our ability to complete tasks, such as household chores, and our willingness to take on responsibility. Sadly, and as we explore below, most of us do not have enough self-awareness at a young age to ensure that our behaviors are the very best ones. In short, they are just the ones that worked and our behavioral technologies are those of a 9-year old most often.

 

Changing Habits is Expensive

It should come as no surprise that to change habits is exceptionally difficult due to conservation and a lack of self-awareness. As we learned with the PCM model, in the (C)entral processing component, if something is familiar our brains invoke default habits. So, if something isn’t broken, we have no hormonal indication that it needs fixing. Hence, behavioral biases. The remedy, as I have written many times and in many places, is: self-awareness. Self-awareness is known formally as metacognition.

It is true that developmentally an awareness that something is wrong occurs at about age 6, but we are ill-equipped to know what is wrong, or to understand different points of view. Sadly, metacognition researchers believe that until about age 11-12 most of us do not have strong metacognition.[7] In other words, one of the causes of behavioral bias is that the capability needed to unwind them – metacognition – is not sufficiently formed until years after the habits themselves are formed.

What this means, and what I have written about exhaustively, is that to overcome behavioral bias requires that we have a way to observe the cues that trigger our habit loops, and a way to interrupt them. Hormonally, none of this feels good. It is work. What this means is that if you are an investor and you can overcome your behavioral biases, then you can be certain you have a difficult-to-compete-against edge over those that do not.

 

[1] Graybiel, Ann M. “Habits, Rituals, and the Evaluative Brain.” The Annual Review of Neuroscience. 2008

[2] Duhigg, Charles. The Power of Habit: Why We Do What We Do and How to Change It. Random House. 2012

[3] See, for example the detailed entry on motivation from Wikipedia: https://en.wikipedia.org/wiki/Motivation

[4] Ibid.

[5] Wood, Wendy, and Dennis Rünger. “Psychology of Habit.” The Annual Review of Psychology. 2016

[6] Pressman, Robert M., Judith A. Owens, Allison Schettini Evans, and Melissa L. Nemon. “Examining the Interface of Family and Personal Traits, Media, and Academic Imperatives Using the Learning Habit Study.” The American Journal of Family Therapy (2014): 1-17

[7] Veenman, Marcel V.J. and Marleen A. Spaans. “Relation between intellectual and metacognitive skills: Age and task differences.” Learning and Individual Differences (2005): 159-176

 

 


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