Type “father of behavioral finance”  into a search engine and the name Daniel Kahneman will populate most of the top results.⁽¹⁾ Kahneman was an eminent psychologist and winner of the so-called Nobel Prize in economics.⁽²⁾

His influence on investment advice can’t be overstated. His work touches us in two ways: first, a number of behavioral and cognitive biases are said to make investors make bad decisions. They go by terms like:  overconfidence effect, loss aversion, availability heuristic, base rate fallacy, and the Linda problem. My personal favorite is the Ikea effect, which (sadly) isn’t central to our work. Here’s a larger list: I promise it’s legible at poster size!

‍

‍

It’s a small step from this line of thinking to the view that an advisor’s main job is to prevent clients from doing “dumb things:” to protect them from themselves. The proliferation of risk tolerance questionnaires as a tool for managing investor behavior is a direct result. Since financial professionals tend to make common errors (like buying high and selling low) at about the same rate, this is an odd framing of our role. Naturally there’s a bias for that too.

The second way it touches us is in investment management. When professors or practitioners identify a potential source of investing edge, they ask whether it represents a “compensated risk” (higher return for more risk) or a common mistake investors make because of biases like the ones listed here. Which one it is (or maybe neither) helps us decide whether we think the edge is sustainable

While we honor Dr. Kahneman’s contributions, there are other theories as to whether some of the behaviors this field studies are truly irrational, or whether we’ve fallen prey to  “bias bias” or lousy experimental design. Perhaps our “irrational” behaviors are just rational responses to uncertainty. Another fascinating line of research seeks to explain these biases using cutting-edge tools from computation and neuroscience. 

We eagerly await further progress in the understanding of human behavior and its impact on investing and personal finance. Perhaps we’ll someday know whether the fault lies in our stars or or in ourselves. Kahneman’s legacy includes some key milestones on that path. Rest in peace.

‍

‍

^{1. Success has many fathers, so the search results will include other contenders.}

^{2. This prize was not established in Alfred Nobel’s will, so it’s perhaps fitting that it should be awarded to more non-economists}