Last week, I focused on listening to the voice of common sense on money issues (“Let common sense be your guide in managing your money”). However, even our “common-sense” thinking can sometimes let us down, as revealed by the figure now regarded as the father of behavioural finance, Daniel Kahneman, who died this week, aged 90, and who is the subject of today’s column.
In his seminal book, “Thinking, Fast and Slow”, Kahneman identified mental traps and biases to which we are prone when thinking about most things, but which are particularly relevant in money matters. This is because we often rely on mental short cuts when making decisions, instead of thinking things through carefully and rationally.
Although he won the Nobel Prize for Economics, Kahneman was a psychologist. Born in Tel Aviv, he studied at the Hebrew University of Jerusalem and went on to begin his academic career there in the early 1960s, after having obtained a PhD in psychology at the University of California, Berkeley.
He and a colleague, Amos Tversky, set to work, in Israel and, later, in the US, on researching how people make decisions in different situations. Their significant body of research is condensed into what became Kahneman’s best-selling book mentioned above, published in 2011, many years after Tversky’s premature death at the age of 59 in 1996.
Kahneman talks about two systems of thinking: intuitive thinking, which is quick and automatic, which he calls System 1; and concentrated thinking, which is deliberate and ordered and involves mental effort, which he calls System 2. Both are necessary for our everyday functioning but, sometimes, we assign to System 1 what should really be a System 2 function. This is because of an inherent mental laziness, which impels us to jump to a conclusion rather than giving a matter the mental effort it may deserve.
Kahneman writes: “Jumping to conclusions is efficient if the conclusions are likely to be correct and the costs of an occasional mistake acceptable, and if the jump saves time and effort. It is risky when the situation is unfamiliar, the stakes are high, and there is no time to collect more information. These are the circumstances in which intuitive errors are probable, which may be prevented by a deliberate intervention of System 2.”
How our minds deceive us
The book covers many aspects of how our minds work. I focus on a few insights relevant to decisions involving money.
• Statistical biases. When presented with statistical information, for example, graphs of share prices, our System 1 often jumps in and sees patterns or attributes causes where none may exist. We tend to underestimate the degree to which randomness plays a role. We also tend to confuse correlation with causation. Just because two events are correlated does not mean one caused the other. For example, the decline in stork populations and human birth rates in Europe show a high correlation, but no one would use it to validate the myth that storks deliver babies.
• Availability bias. Our decisions and views are influenced by how easy it is to retrieve information from memory, or how “available” the information is. A good example is news broadcasts on TV or radio, which focus on bad things such as wars and famines. Dramatic events are more likely to stick in our memory than mundane ones, leading us to think the world is a more dangerous place or the economy is in a worse state than it is.
• Regression to the mean. Luck contributes more to success than we give it credit for, and this is relevant when we assess the performance of investment managers. If a manager performs well, you are more likely to attribute the superior performance to the fund manager’s skill than to luck. The probability is high that the fund manager will perform less well (reverting to average performance) in the future, just as a fund manager who has performed poorly is likely to perform better (also reverting to average performance) in the future. Of course, there are skilful managers that consistently perform well, or are there?
• The illusion of investment skill. Kahneman says research has shown that professional investors fail a basic test of skill: persistent achievement. “For the large majority of fund managers, the selection of stocks is more like rolling dice than playing poker,” he writes. What supports the illusion of investors, both amateur and professional, that they can beat the market? The most potent psychological cause , Kahneman says, is their belief that they are exercising high-level skills, through researching companies and consulting economic data. “Unfortunately, skill in evaluating the business prospects of a company is not sufficient for successful stock trading, where the key question is whether the information about the firm is already incorporated into the price of the stock. Traders apparently lack the skill to answer this crucial question,” he writes.
• Loss aversion. Research by Kahneman and Tversky found that, in a situation where there was the likelihood of a loss or a gain, most people would accept the “gamble” only if the gain was bigger than the loss – for most people this ratio is two to one. “This asymmetry between the power of positive and negative expectations or experiences has an evolutionary history,” Kahneman says. “Organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce.”
Go get a copy of “Thinking, Fast and Slow”, if this has piqued your interest…
* Hesse is the former editor of Personal Finance.
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