Financial Regulation goes Cognitive

Grete Chan, 17 October 2012

How well do you understand the judgement processes that underlie your decisions? Your multiple selves (experiencing, remembering, judging, decision-making, emotional and rational, among others) exert a powerful influence on your behavior, in your daily professional activities and throughout your lives.

That was the introduction of an 100 Women in Hedge Funds education session held this evening at Bloomberg NY with Daniel Kahneman, a Nobel laureate in Economic Sciences for his seminal work in psychology that challenged the rational model of judgment and decision making and acclaimed author of Thinking, Fast and Slow.

The session was truly an intimidate experience, bustled into a room full of ambitious hedge fund saleswomen where I am sure that I was one of the only ones who care two cents about curbing unsubstantiated risk-taking. On the angle of a financial regulation professional, we can definitely benefit from the psychology of decision making in the view of investment professionals to determine the very behavior we strive to deter. This is where rules such as limits on positions, disclosure requirements, transparency and quality controls are used as tools to prevent “wrongful” behavior. What are “wrongful” behaviors? In regulatory sense, that would come in the form of taking advantage of confidential information that leads to trading advantages (unfair practices), fraud or misrepresentation in advice, omission of information, individual gains from others and ruthless gambling (speculative bets) in general amongst others.

Kahneman explains the dual process theory, and breaks down the two systems or minds on one brain. System one is known to be the intuitive or implicit system that produces instinctive or “fast” reactions. System two involves a more explicit or rational or rules-based system that performs in a “slow” and sequential thinking process.

Looking at the investment activity, we can definitely classify the “fast” decision makers with the following actions:

  • Taking speculative bets
  • Hunches influencing buy/sale decisions

As the objective of most intuitive decision makers are to make the quickest buck with the highest possible return, they are likely to be prone to high risk behavior such as:

  • Feedback on performance based on returns (market is unpredictable, returns can vary so it’s not rational)
  • Manipulating High Frequency Trading to individual advantage
  • Overloading machines with orders and cancelling to take advantage of lag time
  • Putting blame of bad decisions on others (which is irrational as market is unpredictable)
  • Overlook bad decisions and do not learn from them
  • Over self-confidence

Kahneman claims that intuition rarely performs well, so for decisions to be well made intuitively, it could be based on luck. He went on to provide example when he advised the recruitment process for an organization, that their hiring decisions based on intuition usually saw poorer performance than hiring decisions based on competency. He recommended that a score card to be followed based on values the firm seeks in a candidate, and to scale all the attributes and hiring based on the score and to forget about intuition.

He then continued to suggest that perhaps a quality control over decision making will make a firm more productive.

On this note, we should take a look at Kahneman’s System 2, on rule-based “slow” decision process. Perhaps financial regulation professionals can apply this system as a method to tackle unwanted over-intuitive decision making amongst investment professionals and promote rational thinking. At the end of the day, compliance and regulations are mainly common sense. Kahneman’s theory pinpointed that whilst our investment professionals are still acting intuitively, there can be no common sense or rational thinking to be found. If we can apply more rational thinking into compliance programs, such as literally applying “quality control” over decision making, then we may have won some ground. As Kahneman puts it, in investment, the product is the decision, therefore there must be quality control over the product.

Quality control can also be multispectrum such as:

  • Preempt unnecessary risk-taking behavior by incorporating the firm’s risk appetite as part of the hiring competencies – should candidate exceed the risk appetite, they should not be hired
  • Implement procedures for high risk products and advice given to customers – the higher risk the product, the more substantiated disclosure the adviser must provide on their decision
  • Dual fiduciary duty for high risk products – clients are at as much fault for allowing their investment manager gamble away their money and should take responsibility for it too. Perhaps an explicit fiduciary duty imposed on clients on their own money will help lower risk appetites of investors and curb speculative bets, and to put less money in the hands of irrational traders
  • Feedback based on the soundness of investment performance rather than returns

With recent catastrophes such as the global financial crisis fueled by speculative bets and oversell of unknown and complicated high risk products such as the subprime mortgage, there is an obvious need to control investment decisions to promote a more balanced and sustainable capitalist environment. While the eye of the storm is slowly passing through, further dangers await ahead that are too accessible by moms and dads.

While recent regulations such as the US Dodd-Frank attempts to curb this behavior with limits and restrictions, Kahneman’s studies show that there are perhaps other ways to tackle the problem, and we may do well to begin with the decision making process.

As the session wraps up, an audience member asks, “Are women different from men in intuition?”

Kahneman laughs, and says, “well… no.”

…….

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