How Daniel Kahneman Created His Legacy: Behaviorism

Prof. Daniel Kahneman. Photograph by Princeton University, John J. Jameson.

A hardy appreciation of irrationality is a prized trait among some of the best investors. Those who saw the threat of the housing bubble before the 2008 market crash can back up that assertion.

And they can thank Daniel Kahneman, who built his academic career and won the Nobel Prize for economics in 2002 on the insight that, contrary to the long-held belief that investors were rational beings, they often are not.

The branch of economics he helped found, behaviorism, charted the many ways people, in general, and investors, in particular, get their thinking warped by emotional reactions, mental shortcuts and other acts not in their own self-interest.

A Ph.D. in psychology who had never taken an economics course, Kahneman died on Wednesday at 90, leaving a big legacy in economics. He sometimes is known as “the father of behaviorism,” a label he dismissed. Kahneman, who taught at Princeton University, already had developed theories about behavioral pitfalls early in his academic career, but his friendship with an economist, Richard Thaler, who won a Nobel Prize in economics in 2017, helped him shift his focus to economics.

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Along with Thaler (based at the University of Chicago) and another professor, the late Amos Tversky (Stanford University), Kahneman developed many theories about poor judgment. One was called “judgmental heuristics,” about the common practice of taking mental shortcuts, which acts to save time but also can lead people astray. Example: learning to beware of slick-talking financial hustlers like Bernard Madoff could lead you to stay out of the stock market entirely.

Kahneman came to wider public notice with his 2011 best-selling book, “Thinking Fast and Slow,” about a duality in human behavior. Thinking fast is emotional and instinctive; thinking slow is more logical and deliberate. The book covered some of his theories, such as “sunk cost,” in which people keep pouring money into an investment even though it is clear the endeavor was a loser.

Behavioral biases are omnipresent, Kahneman wrote—and other research has shown they even effect pension decisionmaking. A 2017 paper by four British academics (three of them in psychology, one in finance) concluded that pension boards of trustees, are deficient in financial know-how, and thus make decisions that are often removed from pure rationality, as Kahneman outlined. Board members let other influences sway them, the paper stated, and so they “have an illusion of effectiveness.”

Kahneman and behaviorism have had widespread influence, including in the world of retirement planning. For instance, Thaler and a younger behavioral economist, Schlomo Benartzi, formerly at the University of California, Los Angeles, two decades ago formulated payroll savings plans that feature auto-enrollment, which overcome employees’ inertia about signing up. These are used broadly now throughout corporate America.

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Tags: Amos Tversky, behaviorism, Bernard Madoff, Daniel Kahneman, economics, housing bubble, Richard Thaler, sunk cost

When institutional investors say they are on the hunt for uncorrelated sources of return, that often means adding a sleeve of trend followers or quantitative strategies to their hedge fund portfolio, but that may be changing. More funds are coming to market chasing investment opportunities off the beaten path, like whiskey or classic cars, while other niches like royalties and intellectual property investing are starting to mature.

An indication of how quickly these markets are maturing came on March 18, when Swiss investment firm Partners Group AG announced it would be adding investments in royalties as the fifth pillar of its private markets platform. According to a firm statement, it will offer bespoke and evergreen structures to invest in intellectual property assets across the pharmaceuticals and entertainment industries in addition to emerging areas including royalties derived from the energy transition, sports and brands. The royalties investment team’s offerings are meant to fit within existing institutional mandates, creating an evergreen vehicle for high-net-worth investors.

Partners Group estimated royalties could be a $1 trillion dollar market, with the potential for rapid growth.

The decision from Partners tracks with what Matthew Farrar, managing partner and head of Aon Advantage Funds LLC, is seeing. “We’ve got a significant transition occurring where intangible assets—like intellectual property—make up almost 90% of the S&P 500,” he says. “These are assets that are hard to understand, hard to value, hard to invest in. You have to build a process that is able to understand and really discern good IP from bad IP, or at least IP that is vulnerable to market forces.”

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Farrar says Aon’s platform tracks approximately 150 million patents across all sectors of the economy, looking at factors like litigation risk, licensing opportunities, country risk, how frequently a company files for new patents and avenues for future development. “Fundamentally, we’re asking whether or not this is a good company to invest in from an IP perspective, and it’s not always an easy question to answer—especially from a private markets perspective, where it might be harder to get the information,” he says.

Still, Farrar adds, institutional investors are interested in these investments because they can provide unique exposure to a company’s growth or a sector theme.

You Can Taste It

While a significant portion of companies are focused on intangible assets, there is still a growing market of investment funds getting involved in tangible assets. At the end of January, Cordillera Investment Partners closed its $62 million Whiskey Opportunities Fund, focused on buying and aging whiskey barrels as institutional assets.

The idea for a dedicated fund grew out of some investments the firm made in its second flagship fund, starting in 2019. According to Gus Araya, co-founder and co-managing partner of Cordillera Investment Partners, the firm started to identify opportunities as supply-and-demand dynamics in the whiskey industry created dislocations in pricing: The market prices for aged whiskey significantly out-pace that for younger whiskey, as consumers are willing to pay up for premium product. According to industry analysts, the volume of sales of super-premium whiskey has grown more than 100% in the past five years.

“Bourbon Boom” revenues in bourbon and Tennessee whiskey grew 249% from 2003 to 2021, according to Distilled Spirits’ “American Whiskey Report 2022.”

“A lot of the craft brands that have popped up over the past 10 years don’t have the scale or the distilleries to sit on product while it ages,” Araya says. “So that’s where investors like Cordillera can come in and use our balance sheet to sit in the middle between wholesale distillers that actually create the whiskey and the craft brands that will bottle and sell it years later.”

Araya says that for investors, the fund will work like a specialized private equity fund. “These are the kinds of opportunities you have to be early to and invest a lot of time up front in understanding,” he explains. “They’re difficult to track, and they’re difficult to underwrite.”

Cordillera as a firm, however, focuses on such opportunities. The fund also invests in other niches, like marina rights and data. Araya says the company’s investors are typically looking for exposure that will diversify their portfolios and is not correlated to any broad market trends.

Start Your Engines

Another firm, Drift Capital LLC, is taking a similar approach to investing in classic and ultra-premium cars. In September 2023, Drift launched its debut classic car closed-end fund, which invests in collectible and luxury cars. Drift is building the portfolio using a proprietary benchmark—the Drift Automotive Returns Composite.

“We are focused on cars that are going to trade and be valued in the million-dollar plus range,” explains Eden Cooper, Drift’s founder. “This is a market that didn’t really exist even 20 years ago, but it speaks to how the valuations of these cars have grown over time.”

The composite is designed to track the value of these cars over time, including collector demand and liquidity. Cooper says the benchmark helps the investment team ensure that the cars in the portfolio are more likely to have lasting value among collectors and investors.

“The compound annual return of the Drift’s automotive composite was 13% over the past 20 years,” Cooper says.

Cooper says the benchmark helps the investment team identify which cars have had lasting value among collectors and investors. In the future, Drift may consider doing maker-specific funds or funds that include cars with newer technologies, like electric vehicles.

Drift targets its offering to institutions and high-net-worth investors, which differentiates it from a small group of fractional ownership funds that are open to a wide variety of investors. Cooper says that while he sees the benefits to fractional ownership—it increases interest in the collectible car market, if nothing else—it is harder for investors who want to write bigger tickets to get into those markets.

Sharing Is Caring

If the art world is any indication, fractional ownership markets can also end up, well, highly fragmented. The art market is no stranger to the involvement of investment funds in acquiring works, and in 2017, a firm called Masterworks LLC made a splash with its fractional investment offering. Since then, however, pricing structures and investment interest have evolved, leading to several new entrants, including recent newcomers InversionArt Inc. and aShareX Inc.

InversionArt and aShareX have come together to offer a new take on fractional ownership at what they say is a lower total cost than that offered by firms like Masterworks. InversionArt and aShareX are launching an auction of works by contemporary artists that will allow a combination of fractional and total ownership using aShareX’s proprietary auction platform.

The bidding is designed to take into account the artist’s total expenses, not just the value of the piece. Artists provide a three-year summary of studio income and expenses, as well as documentation supporting their five most recent commercial sales, commissions and licensing agreements to InversionArt when they are part of the auction. The partnership with aShareX also includes a 10% resale royalty on the sale of the selection of artworks.

Alan Snyder, aShareX’s founder and CEO, says the platform grew out of his prior work creating marketplaces for other financial products, including insurance, credit cards and art lending—a type of direct lending based on the value of a portfolio of artworks.

“Our approach is designed to do more than offer an arbitrary value of a piece; it’s meant to support price discovery and offer true market-based pricing by allowing fractional owners to go head-to-head with traditional buyers,” Snyder says, adding that the lower total cost has garnered some early attention from institutions and high-net-worth investors that did not find alignment with other art funds.

“This is a market that has a lot of interest, and we’re providing a way to access it,” Snyder says. “From institutions, we’re seeing interest in both the tech stack that runs the auctions and the market itself. We think it’s a long-term opportunity and a market that will continue to develop.”

Tags: Alan Snyder, Aon Advantage Funds LLC, aShareX Inc., Cordillera Investment Partners, Drift Capital LLC, Eden Cooper, Gus Araya, intellectual property, InversionArt Inc., Matthew Farrar, Partners Group AG, Whiskey Opportunities Fund

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