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Richard Robb On Understanding Behavioral Finance Via The Rational Choice Model

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ValueWalk set down with Richard Robb — a Columbia University economics professor and the CEO and co-founder of $5 billion hedge fund Christofferson, Robb & Company to discuss the release of his new book Willful: How We Choose What We Do, which focuses on rational choice model. Please find the Q&A below.

Can you tell us about your background?

I have taught economics and finance at Columbia’s School of International and Public Affairs since 2001, assuming a full-time position as Professor of Professional Practice in 2002. 

In the 1990s, I was the Global Head of the derivatives and securities business of The Dai-Ichi Kangyo Bank in New York, London and Hong Kong. I’m now the CEO of Christofferson, Robb & Company (CRC). Founded in 2002, CRC manages approximately $5 bn in hedge funds and private credit, mostly in Europe.

What is your book about?

The book draws on economics and philosophy to explore decision-making. In the classical economic view, rational individuals make choices with the intention of maximizing preferences. Behaviorists, on the other hand, emphasize the influence of mental shortcuts and preexisting biases. Willful argues that neither explanation accounts for those things we do for their own sake, and that without understanding these actions, our picture of decision‑making is at best incomplete. Choices made seemingly without reason belong to a realm of behavior the book identifies as “for‑itself.” Recognizing that life is two-fold—our behavior sometimes serves to advance our preferences and is sometimes for-itself—can help us make better decisions and feel more at ease with the decisions we already make.

Is it based on lessons you learned at your fund?

While my academic training in Chicago School economics was the starting point, yes, lessons from my career in banking and the past 17 years at my fund shaped the theory in this book. 

Can you tell us about the concept of “for-itself”

Certain actions are undertaken not for any tangible benefit but for their own sake. They cannot be ranked against, or traded for, other actions. These actions belong to a realm of behavior that is neither rational nor irrational, but for-itself.

Each for-itself action stands for itself without regard to whether it is better than some alternative. It is undertaken “just because.” It can be a flow or a process, a self-justifying game, or a struggle to overcome a challenge that is not important in any objective way. For-itself behavior includes acting confidently based on beliefs we hold and that matter to us (whether or not those beliefs are accurate) because that’s who we are. Our beliefs constitute our identity and so are not up for sale.

Above all, the for-itself realm emphasizes agency—an individual acting on the world. The rational choice model cannot explain (nor can it be adjusted to explain) how we decide to consume now or later, to retire or continue working. It cannot explain why we procrastinate, engage in random altruistic acts, are inattentive to personal finances, start quixotic businesses and persevere with projects for long stretches without evaluating whether to quit. In contrast, the more fluid for-itself model captures behavior as it unfolds over time in response to the challenges we encounter. 

What lessons do you draw for investors?

Profitable investments (i.e., where the investor can reasonably expect to beat the market ex ante) involve an unknowable encounter with events that differ in important ways from any that have occurred before. Making money requires context-dependent knowledge of particulars like that held by Friedrich Hayek’s “man on the spot.” This can only emerge from experience. It can be sympathetic to ValueWalk’s emphasis on value investing, as I understand it, but more that following a set of rules. 

Yet, markets are not so efficient that the only rational approach is to buy the market portfolio and hang on passively. If markets are efficient, why do all these seemingly rational people spend so much time trying to beat them?

There is no formula for beating the market. If there were a testable rule, everyone would already know it and it would cease to work. Instead, there are lots of rules, many conflicting, and knowing which ones to follow is the whole game. Trades hide in the world. Making money in trading or investing takes you from the realm of signals, risk, and reward into the murkier realm of hunches, judgment, and anxiety.

Behavioral finance is a sucker’s game. When stakes are high, people are pretty smart; even if a few people fall prey to mental shortcuts, the market as a whole will get it approximately right. Additionally, many apparent biases can be explained by rational choice or more naturally categorized as for-itself.

If someone says, “The definition of stupidity [or insanity] is to try the same thing over again an expect a different result,” run from the room. That person will not make money. A profitable course of action may superficially resemble one that lost money in the past. Sometimes you have to draw on your own understanding of the particulars and make a tough choice.

Being independent is not the same as being contrarian. Successful investment requires thinking carefully for yourself, not just doing the opposite of what everyone else appears to be doing.

As an individual investor, don’t beat yourself up for failing to diversify or ignoring other sound advice. Investments are ultimately more than a means of maximizing wealth; they also allow us to express who we are and what we value while undertaking an unpredictable adventure. Even though selling shares in a company that offends you won’t hurt that company’s finances, it’s a valid personal decision. 

The nature of for-itself investing gives individual investors one clear advantage over institutions: while someone trading with her own money lacks the resources of an institution—she can’t

fund the development of a new drug from scratch or buy complex derivatives when everyone else is trying to sell—she can do as she likes. For-itself investing requires a leap outside of settled beliefs. The autonomous individual can more readily take such a leap. The hedge fund manager with tentative control over other people’s money can’t compete with the coordination that takes place within a single mind.

To the extent they can, institutional investors should embrace the for-itself framework. How can institutional investors harness judgment and personal knowledge that reside at the level of the individual while maintaining effective corporate governance? How can they hang on when good trades start out badly? These are key neglected issues in finance. 

What about business owners or salespeople?

Economics tells us that business owners and salespeople have figured out the main lessons of profit maximization without being told. But while none of this should come as news, Willful can put some fairly familiar advice in a theoretical framework:

When we confront a one-time event without the guidance of familiar rules, we’re on our own. This indeterminacy, freedom, and ensuing sense of isolation and responsibility can give rise to dread. Adam Smith expressed it perfectly in 1776 when he suggested that “anxious vigilance” was the defining quality of a good manager, who must often operate under novel and uncertain conditions, doing that which can’t be transcribed into rules and delegated.

Work is more than a sacrifice of leisure in exchange for money that we can use for consumption. Employees crave jobs that involve challenges as well as opportunities for self-discovery and authentic problem-solving. A stagnant firm is no fun to work for.

While the rational choice model focuses on outcomes, making choice passive, no one wants an open-and-shut case—that would leave no room for the exercise of will. Effective salespeople remind consumers that the product exists, then let their reason be a slave to passion. The “soft sell” allows prospective buyers to connect the dots. (This applies to other arenas as well—in movies, and perhaps in real life, people rebel against the romantic interest who seems too perfect.)

Similarly, I wouldn’t worry too much about academic research on the so-called “paradox of choice,” which suggests that dizzying arrays of options put off consumers. Many customers are happy to sacrifice price and quality and engage with a confusing menu in order to exercise their ability to choose. Rather than a nuisance, choice is crucial to the experience.

It sounds like it discusses a lot on behavioral economics. Were you influenced by people like Shiller and Kahneman? 

These days, economists model behavior as dictated by rational choice and derailed by behavioral biases; my belief is that some action falls beyond these bounds. I argue that many phenomena attributed to behavioral biases can be explained in terms of rational choice or the for-itself. I liken behavioral economists’ experiments to optical illusions: entertaining and sometimes instructive, but hardly central to everyday life.

You were mentored by two Nobel Laureates can you tell us about how they impacted you?

They have profoundly influenced my life. Both Ned Phelps and Jim Heckman set an example for me. They are not careerists and don’t care about showing off their cleverness. Rather, they pursue important problems and go where the data and their reasoning take them. 

As I say in Willful

In 2002, a year after I started teaching, I met Edmund Phelps. With his project at Columbia’s Center on Capitalism and Society, he intended to reformulate economics for the modern world. The center sought a theory to describe “real human beings who are not only acquisitive and risk averse but also inquisitive and adventurous and who sometimes feel the need to take a plunge, to leap into the unknown.” This was new. I especially liked the phrase “not only.” There had to be room for both.

The realization that a second realm sits alongside purposeful choice was the turning point for me. Why should one grand system explain it all? People not only seek to gratify desires, but also choose obstacles to overcome. If they succeed, or tire of their project and abandon it, new challenges will arise. It’s natural that this is hard to see, since action can feel more intentional than it really is…

James Heckman was my advisor in graduate school and co-author on academic papers in the 1980s and 1990s, and remains a life-long friend. But when I showed Jim my book, he was skeptical, to say the least. Why did I need a new realm of behavior? Why not just extend the traditional utility function to incorporate new “desires”? These objections set up an important challenge for the book: to use thought experiments as well as logical and technical arguments to show that one realm simply can’t tell the whole story.

It looks like quant is now king again as top stock pickers including famous fund managers slump – how does this square with markets being irrational and profiting off of the panic or mistakes of the crowds What do you make of that

Firms like Two Sigma, DE Shaw, Citadel and especially Renaissance devote massive resources to maintaining their edge and renew themselves through vigilant management. However, several well-known quant funds have recently gotten their comeuppance. 

CRC’s hedge fund, the Bond Opportunity Trading Fund, relies mostly on judgment formed out of long experience in financials, knowledge of banks and knowledge of global regulation. The Fund, which uses active shorts, has a Sharpe Ratio of 3.7, annualized net returns of 11.8% and a negative beta over its three-year life. While we have models and technology like anyone else, it’s far from a quant fund.

You have done some writings on problems with modern day capitalism we are getting a lot of warnings from big names like Dalio and Paul Tudor on inequality on the other hand others like Leon Cooperman think there is no cause for alarm – what are your thoughts on the matter? 

The economy uses money. Some hedge fund managers have a lot of money. That doesn’t mean they know a lot about political economy.

Can you explain the “monetary value of life”

Sometimes, when operating in the rational choice realm, we must equate a monetary value to a human life. An example would be a government setting speed limits. Lowering the limit saves a few lives but causes a lot of inconvenience. To do its job, the government must assign a dollar value to the potential lives lost as well as the inconvenience.

At other times, we confront a single individual and drift into the for-itself realm. Philippa Foot’s Trolley Problem, for instance, isn’t going to yield to rational analysis (unless you’re a strict utilitarian). In one of the most famous versions of this problem, you must push a fat man onto the tracks to save five children or not push. Either way, it’s a one-time act of will.

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