Over the last several weeks we have been exploring A Theory of Behavioral Finance. So, far I have provided a high-level overview of the theory, as well as a discussion of two of the parents of behavioral bias: biology and psychology. In this article I discuss the sociological factors that lead to our errors in judgement.

For convenience, here are the sociological factors that I outlined previously:

4. Sociological factors affecting human behavior include:
   1. Safety
   2. Group feedback that is either positive or negative about attitudes, behaviors, and choices

Why Sociology is Important for Understanding Bias

It should come as no surprise that most people care about what others think of them. Most people also are concerned with how well they fit in with groups. Why?

It is easy to imagine a time in the distant past when people survived the rigors of nature – unpredictable weather, finding food, defending against violence – because of safety in numbers. Standing alone against the world was nigh impossible in our ancient past. Surely affiliation with a group of people increased the likelihood of survival. While seemingly obvious, this idea remained hidden in the shadow cast by the light of Darwin’s evolutionary theory for almost a hundred years. Why would I cooperate when I need to be selfish to survive?

That cooperation is important for survival is supported by evolutionary biologists who have demonstrated this idea mathematically. Pioneering work in 1964 by Hamilton provided key insights as to why individuals’ ideas of survival of the fittest was not solely a selfish-impulse.[1] Specifically, his work found that organisms do not reproduce, genes do. Genes that are shaped by a need to survive can do so in two ways: 1) an organism can reproduce itself by passing its genes to its offspring; or 2) it can help other organisms that share its genes, such as its relatives. Subsequent researchers over the decades continue to affirm these findings, as well as that cooperation is key to survival.

A modern investing education usually includes a short detour into game theory. Typically, what people remember after this diversion is the Prisoners’ Dilemma. Here, co-conspiring criminals facing prosecution “win” by selling out their partner in crime and labeling them as the primary instigator. Yet, as I have written elsewhere this strategy only holds in a very limited set of circumstances and that cooperation is almost always a better strategy. Other game theorists have researched and found the same thing. For example, Nowak and Sigmund found that, “Cooperation pays because it confers the image of a valuable community member to the cooperating individual.”[2] Their work with computer simulations finds, “the emergence of indirect reciprocity was a decisive step for the evolution of human species.”[3]

In summary, the survival of the species depends, in part, on how well groups perform vs. nature. Group performance, in turn, depends on how well the members of the group work together and how they fit together.

Finally, that belonging to a group is important to people is also made obvious when you consider the way that we punish people for violating the laws or norms of a group. In short, we punish people by pushing them further away from the group. A violation of family norms can result in being “sent to our room,” or if the violation is worse, in “grounding.” Here the misbehaving child is cleaved off from the group temporarily.

Within society people who violate the law severely enough are carved out from society and sent to prison. Violations within prison can lead to solitary confinement, which many consider a truly severe punishment. Some even label solitary confinement as inhumane which is strong evidence that group affiliation is important to people.

Proof that we are social creatures is that solitary confinement has profound effects on our biological and psychological health. Solitary confinement is associated with a 26% increased risk of premature death stemming from our stress response which dumps cortisol into our system and increases blood pressure and inflammation.[4] It is also well-known that increased isolation increases our risk for suicide.[5] Long-term solitary confinement leads to very strange effects such as the inability to recognize faces, and to learn new things due to the damage it does to the hippocampus.[6]

Closer to home, and here I am talking about at investment firms, those that fail to thrive within the culture of their firms either leave or are eventually fired. Many investment organizations spend large amounts of time trying to identify the type of culture they want at their firms, and then they actively hire people in conformity with their culture. This is verified by a perusal of one of the investment industry’s leading consultancies Focus Consulting Group’s “Writings” section of its website.[7] Their site features 5 whitepapers on culture, as well as 13 articles just on its main page. Additionally, the titles of these writings are telling, too:

• “Linking Strong Culture to Success”
• “Managing Culture: Leaders as Shapers of Reality”
• “Culture as a Strategic Advantage”
• “Commercial Success and Culture”
• “Good Cultures Don’t Scare People”

In other words, groups functioning well sociologically are a key concern of investment organizations. We can also conclude then that to succeed in investment organizations partially requires that we are:

1. Fluent with our group or organization’s norms
2. Behave in accordance with our group or organization’s norms

As demonstrated in my other articles on behavioral biases, they arise when we fail to understand reality for what it is, and instead respond reflexively to situations. Group norms are the very definition of reflexive responses to reality.

For example, how easy is it for a research analyst to pitch a waste management business to a portfolio manager if the firm has been hurt by the performance of waste management companies in the past? Or, how easy is it for a research analyst serving on a value product to stretch the valuation norms when pitching a stock? How easy is it for a member of an investment committee to ignore a group decision and purchase a stock on her own?

I am not arguing that we ignore the sociological expectations of our organizations to avoid behavioral bias. Instead, I am arguing that sociology and the anxiety of being rejected by the group is a powerful incentive to behave in very particular ways. I am using strong examples to indicate that sociology does bias decision sets by limiting our available decisions. Consequently, to fully understand behavioral bias, we need to consider the group setting.

With regard to the classic behavioral biases themselves, some firms have established risk averse cultures where loss aversion is more likely to express itself. While still other cultures may prefer cocksure thinkers and have a “survival of the fittest” environment where analysts fight for their ideas to end up in the portfolio. Here overconfidence is more likely to be present sociologically. And so on. In my work as a consultant working with organizations the very hallmarks of the investment culture are also frequently the sources of institutionalized behavioral bias.

Group Feedback Matters

Hopefully the discussion above strongly indicates that bias is likely to be reinforced, if not outright created by the social milieus in which we work. But there are even biological effects caused moment-to-moment by the feedback we receive – positive or negative – from our groups.

In my previous articles in this series I described a model of the brain and how we use it to make decisions. Importantly, the final part of the decision-making loop is “feedback.” That is, after we make a decision we observe the consequences of our choice. If the result of our decision is a favorable outcome then our brains release hormones that feel good to us. Whereas, if the outcome is poor then hormones that do not feel good are released. This feedback mechanism reinforces the development of our behaviors, habits, reactions, and so on.

But how does the brain treat feedback from the groups in which we partake? “[T]he brain transforms socially constructed rewards into the same ‘common currency’ [i.e. hormonal neurotransmitters] as ‘natural rewards.’”[8] In other words, at the level of our brains there is no difference. Furthermore, these researchers found, “If positive expected value is somehow coded by activity in these ‘reward regions,’ then investigators should be able to predict participants’ choice behavior based on activation of these regions. This idea was recently explored by Kuhnen and Knutson (2005) who hypothesized that an increase in gain anticipation would promote risky choices, whereas an increase in loss anticipation would instead promote riskless choices.” This is direct evidence that our social interactions contribute to our behavioral biases.

[1] Hamilton, W.D. “The genetical evolution of social behaviour.” Journal of Theoretical Biology (1964) 7, 1-16

[2] Nowak, Martin A. and Karl Sigmund. “Evolution of indirect reciprocity by image scoring.” Nature. Vol. 393 (11 June 1998): 573-577

[3] Ibid.

[4] Holt-Lunstad, Julianne, Timothy B. Smith, Mark Baker, Tyler Harris, and David Stephenson. “Loneliness and social isolation as risk factors for mortality: a meta-analytic review.” Perspectives on Psychological Science Vol. 2 (March 2015): 227-237

[5] Calati, Raffaella, Chiara Ferrari, Marie Brittner, Osmano Oasi, Emile Olié, André F. Carvalho, and Philippe Courtet. “Suicidal thoughts and behaviors and social isolation: A narrative review of the literature.” Journal of Affective Disorders Vol. 245 (15 February 2019): 653-657

[6] Joo-Kim, Eun, Blake Pellman, and Jeansok J. Kim. “Stress effects on the hippocampus: a critical review.” Learning & Memory. Vol. 22, 411-416

[7] Writings. Focus Consulting Group. http://www.focuscgroup.com/writings/ Accessed 7 December 2020.

[8] Winkielman, Piotr, Brian Knutson, Martin Paulus, and Jennifer L. Trujillo. “Affective Influence on Judgments and Decisions: Moving Towards Core Mechanisms.” Review of General Psychology (2007). Vol. 11, No. 2: 179-192