There’s no doubt behavioral finance research has had a tremendous influence on our general understanding of human behavior. From loss aversion, to choice architecture, to the “Bottom Dollar” effect, and more – behavioral finance research has enhanced both our understanding of real-world financial behaviors, and what financial advisors must watch out for while trying to assist their clients in making wise(r) financial decisions.
However, despite its tremendous influence, behavioral finance research leaves a lot to be desired. Most notably, while behavioral finance has taught us a lot about how people behave, it tells us very little about why we behave how we do – and understanding why we behave the way we do is important to ensuring that we understand the circumstances in which biases, heuristics, and other behavioral quirks may lead us astray (so that we can then avoid or manage those circumstances).
In this guest post, Dr. Derek Tharp – lead Researcher for Kitces.com, and an assistant professor of finance at the University of Southern Maine – examines the weakness of behavioral finance as a field, and why evolutionary psychology may likely grow to become a more useful framework for understanding how humans make financial decisions.
In essence, the “problem” with behavioral finance research is that it is largely atheoretical, functioning more as an ever-growing catalog of human behaviors which do not align with traditional assumptions of rational behavior. Of course, cataloging interesting behavioral phenomena is not inherently a bad thing to do, and there is tremendous value in the cataloging work that has been done. But the reality is that a mere catalog of interesting financial behaviors is less insightful than a true theoretical perspective, especially when it comes to providing any real insight about what individuals (or their advisors) should do about those problem behaviors.
By contrast, evolutionary psychology, which applies Darwinian evolutionary principles to human psychology, can not only provide a rationale for why we engage in behavior such financial behaviors as the endowment effect or hyperbolic discounting, but also insight into the conditions in which we are most inclined to be misled. Specifically, humans must be most concerned when a bias or heuristic was functionally useful within the environment in which our ancestors evolved, but is no longer as relevant within our modern world. Further, evolutionary psychology also provides insights into areas such as communication, positive psychology, and psychopathology, suggesting that evolutionary psychology has much to offer financial counselors and therapists as well.
(Michael’s Note: This post was written by Dr. Derek Tharp, lead Researcher at Kitces.com and an assistant professor of finance at the University of Southern Maine. In addition to his work on this site, Derek assists clients through his RIA Conscious Capital. Derek is a Certified Financial Planner and earned his Ph.D. in Personal Financial Planning at Kansas State University. He can be reached at firstname.lastname@example.org.)
Rational Choice Theory
The proliferation of behavioral finance research in recent decades can make it easy to lose sight of just how useful its predecessor, rational choice theory, has been.
The key idea of rational choice theory is that individuals generally pursue the actions which they believe will best further their goals (i.e., they will make rational maximizing decisions). And, as it turns out, this assumption is highly useful in predicting at least most human behavior.
Of course, it’s not always correct, and it’s not always easy to determine what “rational” behavior truly is in the first place, as there are many different competing definitions of what it means to be “rational” and different methods for operationalizing the theory. Still, though, humans act in a manner that generally aligns with what rational choice theory would predict far more often than not (using a basic mostly-common-sense understanding of rationality).
Rational choice theory really shines in situations in which “rational” actions may not seem so rational at first glance. For instance, while we would not be surprised to learn that a person attempts to procure food when they are hungry, we may be surprised to learn that putting insects and rodents on trial was once a common legal practice. The rational explanation for why we eat when we’re hungry is so obvious as to not be useful, but a rational explanation for putting vermin on trial (if one exists) could shed useful light on a human behavior that otherwise seems quite irrational.
In a 2013 paper published in the in the Journal of Law and Economics, economist Peter Leeson examines the common practice of putting vermin on trial in the French, Italian, and Swiss ecclesiastic courts from the 1400s through the early 1700s. Despite puzzling historians for hundreds of years, Leeson argues that rational choice theory can explain this odd behavior.
While Leeson’s full argument is too nuanced to concisely present here, the gist of Leeson’s argument is that conducting vermin trials was a profit-maximizing activity of the early modern Catholic Church. Because tithing (giving 10% of income) was essential for the revenues of the church (and tithe evasion therefore very problematic), and because a large enough portion of the population believed in (or at least feared) the divine power of the church, the church could take advantage of the fear of vermin-caused natural disasters as a means of creating self-imposing tithe compliance. From the religious individual’s perspective, tithing became “worthwhile” to ensure they had access to the church courts to put vermin on trial as a potential means to “avoid” natural disasters through the church’s perceived divine powers… while the church accommodated the vermin-on-trial process because it helped to ensure local farmers continued to tithe (as the courts and their divine support would not be available to the farmers if they evaded their tithes).
Leeson has made a career out of explaining weird and previously-not-understood human behavior through a rational choice perspective – including his work on topics as diverse as the economics of pirating, witch trials, and his recent collection of analyses in WTF?!: An Economic Tour of the Weird (including topics such as wife sales [counterintuitively argued to benefit unhappy wives within a legal system which otherwise failed to provide women with equal rights], the use of poisoned chickens to resolve disputes, and trial by battle).
The wide range of topics covered by researchers like Leeson illustrates the tremendous power of a good theory: One simple set of concise assumptions can be formalized into a model with a high level of predictive validity in the real world. Setting aside the legitimate-albeit-nuanced debates over important topics within rational choice theory (e.g., How do we define “rational?” Is rationality “bounded?” Etc.), researchers can take (and have taken) this theory and make reasonable predictions in a wide range of contexts. As a result, rational choice theory is a useful lens through which we can view and better understand the world.
By contrast, behavioral finance does not offer the same sort of utility in broadly gaining a better understanding of the world. Lacking any unified theory, there is no single lens – even if imperfect – through which we can look at the world and try to gain a better understanding. Of course, we can pick up lots of different lenses via the extensive catalog of biases that have been identified, but this lacks the parsimony of a true theoretical framework (such as rational choice theory). Thus, while rational choice theory can be applied to nearly any topic involving deliberate human action, choosing the “right” behavioral finance insight must always be evaluated on a case-by-case basis, and it’s often hard to know if we are trying to apply a theory in a situation in which it would not apply.
Nonetheless, we know some behavioral finance lenses do make sense in some situations, as the deviation from predicted behavior under rational choice theory is why this catalog of “irrational” behaviors was developed in the first place. So can we do better? Is there a unifying theory of behavioral finance?
The Promise of Evolutionary Psychology
In its simplest form, evolutionary psychology is the application of Darwinian evolutionary principles to human psychology.
Mention of Darwinian evolution often brings to mind the phrase “survival of the fittest,” which, although not originally used by Darwin himself (Herbert Spencer gets credit for this phrase), was eventually used approvingly by Darwin. However, modern connotations associated with the phrase (e.g., survival of the strongest or the most ruthless) can give a false impression of what Darwinian evolution is actually about.
A core element of Darwinian evolution is natural selection – which is the tendency for organisms that are better suited for their environment to pass more genes on to future generations. Evading threats in one’s environment (i.e., survival) is one way in which organisms may tend to pass more genes on to future generations, but so too are ways in which organisms may improve reproductive success. In fact, in some cases, both survival and reproductive success can be enhanced through altruistic behavior, so the connotations of Darwinian evolution as a sort of ruthless survival are incorrect and fail to appreciate the nuanced ways in which natural selection actually plays out. In short, evolutionary psychology is the examination of the ways in which human psychology has been shaped by natural selection.
And while it may not be the case that evolutionary psychology can explain everything within behavioral finance, it is already emerging as a highly powerful tool which, beyond the mere cataloging of behavior, allows us to understand why humans behave the way we do (including in various “irrational” scenarios), as well as predict conditions in which our less-than-fully-rational behavior may be led astray.
Thus, while only time will truly tell, evolutionary psychology appears to be the leading candidate for the type of broad theoretical perspective which could be paired with rational choice theory to be both parsimonious and highly explanatory of human behavior, including many otherwise-puzzling and “irrational” financial behaviors. In fact, in Evolutionary Psychology and Economic Theory, David Friedman describes evolutionary psychology as a “theory of mistakes” which pairs nicely with rationality as a theory of when we get things right. Specifically, Friedman says (pp. 19-20):
One way in which evolutionary psychology modifies the rationality assumption is by predicting what objectives individuals are likely to have. A second is by providing a theory of mistakes.
Compared to rational thinking, Darwinian evolution is a slow process. While we expect economic man to choose the actions that achieve his objectives in the environment he observes around him, we expect evolutionary biological man to be designed to achieve his objectives – more precisely, his genes’ objectives – in the environment in which his species evolved. It follows that individuals are likely to be irrational – designed to act in ways not well designed to achieve their objectives – when the relevant features of the environment have changed rapidly enough so that evolution has not yet had time to catch up. The theory predicts not merely that individuals will make mistakes – that we already knew – but what mistakes they will make. They will make those mistakes that would have led to reproductive success in the environment in which the psychological characteristics leading to those mistakes evolved.
Friedman also provides what he describes as the two simple assumptions of evolutionary psychology:
The human mind is best understood not as a general purpose computer but as a set of specialized software modules, each designed to deal with a particular subset of problems.
Those programs have been designed by Darwinian evolution to produce reproductive success in our environment of evolutionary adaptiveness – the hunter-gatherer environment in which our species spent most of its species history.
An important insight from evolutionary psychology, as noted in Assumption #2 above, is that we humans evolved within environments very different from those in which we live today. This may result in a mismatch between the psychological mechanisms we evolved within our ancestral environment (formally referred to as our “Environment of Evolutionary Adaptedness”) and the demands of the environments we live in today. If this mismatch does exist, then we ought to expect that we will be particularly prone to making mistakes in our current environment.
(Derek’s Note: There is much more to evolutionary theory, and it is, unfortunately, an easy theory to misapply. For a deeper dive into the topic, see here for a list of recommended readings.)
Another key concept of evolutionary psychology is “inclusive fitness” – i.e., the ability to pass genes on to the next generation. As a result, much of evolutionary psychology naturally focuses on topics directly related to passing genes such as mating, but also topics indirectly influencing the success of one’s genes making it to future generations, such as parenting and caring for other family members.
At first, this may seem to have little application to questions related to personal finance, but the reality is that the management of one’s scarce resources has always been a core task of humans. However, resource management within the context of a hunter-gatherer band – our ancestral environment – was much different than it is in our current environment. As such, it’s not surprising that we struggle with all sorts of behavioral challenges related to resource management, especially when dividing resources amongst the family unit. The “specialized software modules” which evolved to help us survive in the context of a hunter-gatherer band are no longer necessarily relevant – and in some cases outright detrimental to – the successful management of resources in the 21st century.
(Derek’s Note: It’s important to keep in mind that evolution timeframes are very long. While some forms of rapid evolution might occur over several generations, more typical evolutionary timeframes are hundreds of thousands or millions of years, suggesting that our evolved behavioral quirks are unlikely to be selected out of the gene pool in a short period of time.)
Applying Evolutionary Psychology to Insights from Behavioral Finance
In Evolutionary Psychology and Economic Theory, David Friedman provides some excellent examples of incorporating evolutionary psychology into a rational choice framework. For instance, Freidman suggests that well-known findings from behavioral finance such as inconsistent time preferences and the “endowment effect” have evolutionary explanations.
Consider the endowment effect example, a classic decision “quirk” of behavioral finance. According to the endowment effect, we value something more merely because we own it. The famous example here involves giving one half of a group a coffee mug and then surveying the group to see the prices at which they would be willing to buy or sell the mug. In theory, the prices should roughly average out (i.e., randomly assigned buyers/sellers shouldn’t systematically differ in their valuation of the mug), but what researchers find is that those who own the mug consistently demand higher amounts to sell the mug than those who do not own the mug would be willing to pay to buy the same mug. This is perceived as irrational, in the sense that our valuing of objects should be indifferent to whether we currently do or do not own an object in the first place.
Notice, however, that although we know of the endowment effect, merely knowing this does not tell us why the effect exists, nor does it help guide us to the situations in which it may or may not be appropriate to apply the endowment effect. At best, we can examine past studies that have identified the endowment effect and try to guess at the circumstances in which it may actually be useful, instead of an “adverse” behavioral bias.
However, looking at Friedman’s evolutionary explanation of the endowment effect can help us see how evolutionary psychology can be useful in understanding long-observed behavioral phenomena.
First, Friedman notes that this effect is not isolated solely to human behavior. While this is not a requirement of evolutionary theory, the fact that other animals (and particularly our closest primate relatives) who were subject to a similar ancestral environment exhibit similar behavior provides some degree of confidence that we aren’t merely looking at some isolated quirk of human behavior and attempting to craft a ”just-so” story that doesn’t actually explain reality.
In particular, Friedman notes that many species of animals exhibit territorial behavior and will fight harder to protect their own territory than they will to conquer the territory of another animal. Friedman explains why such behavior is logical (p. 27-28):
The logic of the situation is straightforward. Unless the trespasser is much stronger, a fight to the death is a losing game for both parties, since even the winner risks substantial injury. The claimant has somehow committed himself to fight more fiercely the closer the trespasser gets to the center of the territory. The trespasser, recognizing that commitment, eventually backs down and retreats. Presumably the commitment is accomplished through a behavior pattern hard-wired into the psychology of a territorial species. . .
Now consider the same logic in a hunter-gatherer society with no external institutions to enforce property rights. Imagine that each individual considers every object in sight, decides how much each is worth to him, and then tries to appropriate it, with the outcome of the resulting Hobbesian struggle determined by some combination of how much each wants things and how strong each individual is. It does not look like a formula for a successful society, even on the scale of a hunter-gatherer band.
There is an alternative solution, assuming that humans are at least as smart as dogs, robins, and Siamese fighting fish. Some method, possibly as simple as physical possession, is used to define what belongs to whom. Each individual commits himself to fight very hard to protect his property – much harder than he would be willing to fight in order to appropriate a similar object from someone else’s possession – with the commitment made by some psychological mechanism hard-wired into humans. The result is both a lower level of (risky) violence and a more prosperous society.
Notably, even Friedman admits that his theory is speculative and ideally would be supported with much stronger empirical evidence, but through this application of evolutionary psychology to the endowment effect, it is clear to see the value that evolutionary psychology adds.
Notice how the why behind the theory helps us understand the circumstances in which we might expect the endowment effect to manifest. For instance, since bands of hunter-gatherers commonly lived in small groups and possessed their wealth in tangible material format, we might expect the endowment effect would be particularly pronounced for similar types of physical objects (e.g., a coffee mug). By contrast, it’s possible (though not necessarily the case) that the same effect may not manifest (or at least manifest differently) for intangible assets such as intellectual property since intellectual property in its current form is not something that existed within our ancestral environment. This is a crucial hypothesis which we do not have via an atheoretical model of the endowment effect.
Other Potential Examples of Applying Evolutionary Psychology to Personal Finance
Because evolutionary psychology deals with the development of all human psychology, there’s ultimately no topic which is truly out of reach. In the extreme, evolutionary psychology could come to subsume all of behavioral finance, leaving the field as little more than a once useful catalog of the various heuristics and biases that influence human behavior.
Additionally, evolutionary psychology can help provide interesting insight into personal finance questions that have largely remained unexplored. For instance, The Elephant in the Brain: Hidden Motives in Everyday Life, by Kevin Simler and Robin Hanson, is a recent book which examines all sorts of interesting human behaviors and motivations influenced by our evolutionary pasts. Skimming the broad range of topics covered in their book, including competition, norms, cheating, self-deception, counterfeit reasoning, body language, laughter, conversation, consumption, art, charity, education, medicine, religion, and politics, can likely generate all sorts of ideas for interesting applications to personal finance research.
It is worth noting that this exploration is not always comfortable. If Simler and Hanson are correct, we often engage in both deception and self-deception to hide our true motives, because, as highly social creatures, we are constantly competing with one another and looking to promote ourselves (even while we may be pretending to do otherwise).
Consider hyperbolic discounting, in which we tend to prefer smaller, immediate payouts over larger, delayed payouts. The common example of hyperbolic discounting is the tendency for individuals to prefer, say, $1,000 today over $1,100 next month, but to also prefer $1,100 in 13 months over $1,000 in 12 months. Rationally, the value of earning an extra $100 over the span of 1 month should be equally valuable no matter when it’s earned, but in practice, we “hyperbolically discount” the value of the extra $100 when the alternative is to get the $1,000 now.
In Evolutionary Psychology and Economic Theory, Friedman argues that there is an evolutionary explanation for hyperbolic discounting: Although modern financial instruments allow us to be reasonably confident in promises from others to provide resources in the future, such promises could not be reasonably guaranteed in our ancestral environment, and humans, therefore, evolved psychological mechanisms which lead to skepticism of such promises that are not warranted in our current environment. In other words, “a bird in the hand is worth two in the bush” may be a hard-wired mental attitude crafted by evolution.
If Friedman is correct, then there are obvious implications for topics such as selecting an annuity payment versus a lump sum distribution. However, if Simler and Hanson are also correct, then there are also additional (and perhaps much more uncomfortable) evolutionary considerations to this topic from an advisor’s perspective. For instance, consider the fact that advisors solely compensated by AUM stand to benefit more financially from clients selecting the rollover option over annuitization. While there is a clear financial motive for an advisor in these circumstances, we may expect animals with social brains such as ours will find ways to deceive others of our pursuit of selfish motives. Further, since deception is generally more effective when we genuinely do not believe we are engaging in such behavior, then we may also expect animals with social brains such as ours to engage in self-deception as a means to earnestly convince ourselves that our motives are something other than what they truly are. (The evolutionary arguments themselves in support of deception and self-deception as an evolved psychological mechanism that promotes inclusive fitness can be a bit more complex than is necessary to cover here, but such theories do exist.)
The result of this combination of biases may be a considerable bias from both the client and the advisor against annuitization. Economists have long been puzzled at the fact that humans don’t engage in more annuitization of their wealth, and financial planning academics have commonly acknowledged that at least partial annuititization could benefit many. Yet, annuitization remains highly unpopular among financial planners, and particularly those who are compensated via AUM fees. Unlike any theoretical framework to emerge from behavioral finance, evolutionary psychology provides a framework which can simultaneously account for biases against annuitization at both the advisor- and the client-level.
As Simler and Hanson warn, pointing a spotlight on some of our uglier motives (motives perhaps so ugly that we’ve evolved ways to help us remain blind to them) can be an unpleasant process, but despite how uncomfortable these topics may be, there is ultimately a lot of value in beginning to have a much richer understanding of our financial motivations and behavior. Ultimately, evolutionary psychology can help us better understand questions such as why we so desperately want to keep up with the Joneses (or why some of us do not), and evolutionary psychology can help us understand not only why we so commonly make certain financial mistakes, but how and why we avoid dealing with such issues.
Additionally, evolutionary psychology provides significant opportunity to learn more about human communication and the ways in which financial planning practitioners engage with their clientele (which, as advisors increasingly focus on facilitating behavioral change for clients, will only be of increased importance).
Beyond Biases and Heuristics
Evolutionary psychology also goes beyond the biases and heuristics so commonly focused on within behavioral finance. In fact, while Friedman is correct to note that evolutionary psychology provides a “theory of mistakes,” which makes for a powerful augmentation of rational choice theory (as a “theory of getting things right”), the potential relevance and scope of evolutionary psychology may be perceived too narrowly from this framing.
Consider the field of positive psychology. Like behavioral finance, much of positive psychology is merely descriptive and atheoretical in its approach. There are frameworks such as Seligman’s PERMA framework which suggests that Positive emotion, Engagement, Relationships, Meaning, and Achievement are important components of happiness or wellbeing, but, like behavioral finance (with respect to biases and heuristics), this is really just a cataloging of factors that have been found to correlate with happiness. It doesn’t give us guidance, for instance, to when any of the PERMA factors may be counterproductive to promoting wellbeing.
However, positive psychology is also at its best when grounded in evolutionary theory. Consider Barbara Fredrickson’s broaden-and-build theory of positive emotion. From an evolutionary perspective, negative emotions were generally much easier for psychologists to explain. When an individual in our ancestral environment heard something rustling in the grass, negative emotions, such as fear, would narrow one’s thought-action repertoire (i.e., the collection of reactions and motor responses one may engage in). In the extreme, the thought-action repertoire is narrowed all the way to “fight or flight,” and from an evolutionary perspective, our ancestors who responded to perceived threats in their environment with a fight or flight response tended to survive at a greater rate, therefore passing on more genes to future generations.
But what about positive emotions? According to Fredrickson’s theory, positive emotions expand our thought-action repertoires instead of narrowing them, which then allows us to engage in behavior that helps us build skills and resources that we can draw on at a later time. For instance, consider playful behavior of children. Under the right conditions (e.g., a safe environment), children experience positive emotions that promote playful behavior. This playful behavior is useful in building the types of social skills and relationships that would have led to greater survival or reproductive success in our ancestral environment. In other words, when we experience positive emotions we’re willing to engage in behaviors we otherwise wouldn’t (i.e., expansion of the thought-action repertoire), and these behaviors help us to acquire skills and resources that are useful in the future.
In contrast to PERMA, which merely told us that positive emotions are important contributors to happiness, note how evolutionary psychology can provide a much richer understanding of positive emotion, including insight into contexts in which positive emotion may both promote and hinder psychological well-being.
And positive emotions are just one example outside of typical behavioral finance research. There’s also an emerging field of evolutionary psychopathology – which further illustrates the power of evolutionary psychology. Evolutionary psychologists are working towards evolutionary explanations of not just behavioral finance, but also psychopathology and positive psychology, and evolutionary insights are likely to be relevant to effectively all of psychology.
Limitations of Evolutionary Psychology
Notwithstanding the benefits of having a more robust theoretical framework for understanding human (financial) behaviors, there are some notable limitations to evolutionary psychology.
First, as mentioned above, it is an easy theory to misunderstand. Some common misconceptions noted in David Buss’ textbook Evolutionary Psychology: The New Science of Mind include the following:
- Human behavior is genetically determined
- Evolutionary adaptations cannot be changed
- Current adaptations are optimally designed
Regarding Misunderstanding #1, the evolutionary perspective does acknowledge that both “nature” and “nurture” matter to the development of human beings. Though genetics play an important role in our development, including the possible predisposition towards or against certain behaviors, genes do not solely determine our behaviors themselves. An example given by Buss is the human development of calluses. We would not develop calluses without the requisite genes for doing so. However, it’s not as if we are predestined to develop calluses just because we have a gene for developing calluses. Instead, it’s only through engaging with our environment in a specific way (e.g., hard labor with one’s hands) that calluses would actually emerge.
Regarding Misunderstanding #2, it is not necessarily the case that adaptations that were developed through evolution cannot be changed. Knowledge, in particular, allows us to modify both our physical environments and our social environments. Buss gives the example of studies which have found that men have a lower threshold for perceiving sexual intent in behavior then women do. Armed with the knowledge that men tend to overperceive sexual intent relative to women, men can use this knowledge to help them avoid misinterpreting messages being sent by women, and therefore avoid placing women in uncomfortable situations. Another common example is birth control. Every time humans use birth control, they are fighting against evolutionary adaptations which promote reproduction. (Pardon the sexual examples, but, as mentioned previously, mating behavior has been one of the core areas of focus in early evolutionary psychology research.)
Regarding Misunderstanding #3, it is simply not the case that what emerges from evolutionary development will necessarily be an optimal design. Evolutionary adaptations will tend to have benefits that outweigh their costs (at least within the ancestral environment), but it is not the case that what emerges is optimal, and particularly not in light of changing environments. To modify an example given by Buss, imagine a world in which a simple vaccine could be given that would make humans immune to all snake and spider bites. Our evolved fear of these creatures (which is likely today somewhat excessive given our typical frequency of encountering such animals relative to those in our ancestral environment, as well as the widespread availability of antivenom) would provide a drastically reduced benefit to us since we’d no longer be subject to any venomous risks. At best we might avoid some discomfort from getting bit here and there, but the seemingly innate fear most have of such creatures would provide no survival or reproductive benefits to help facilitate the passing of one’s genes onto future generations. Simply put, while our genes are not solely determinative, sometimes we will remain tethered to our hard-wired tendencies even in the midst of a knowingly-different (e.g., more modern) environment.
It is also the case that research in the area of evolutionary psychology is hard. We cannot, for instance, run controlled experiments in which we evaluate the true effects of human evolution. And we also cannot directly observe evolutionary phenomena (given that it occurred thousands or even millions of years in the past). Some carry this criticism too far in dismissing the potential to evaluate evolutionary theories, but the reality is that it’s not easy to test evolutionary theories in many cases, and there are instances of researchers getting the theory dramatically wrong.
Nonetheless, evolutionary psychology provides considerable opportunity to learn more about not just our human motivations and behaviors, but also those motivations and behaviors specifically in a financial context. So much so, that this field could conceivably subsume all of behavioral finance in the future. Of course, that’s not to say that behavioral finance was not useful and will not continue to be useful in the interim, but in the long run, it will be perspectives which can answer the why and not just catalog the what of our financial behaviors that will be the most informative and useful to financial advisors.