A Tribute to Daniel Kahneman

A famous psychologist who studied how people make economic decisions, passed away at the age of 90. He won a Nobel Prize for his work on how our minds influence decision-making. 

He wrote books like "Thinking, Fast and Slow" and "Mistakes Bound to Happen," which have changed the way we think about money and behavior.

There are hard-wired mental biases that can warp judgment often with counterintuitive results.

His research showed that our brains often make mistakes when it comes to money. Sometimes, we don't even realize we're doing it!

Here are some important biases from his book "Thinking, Fast and Slow" that we can learn from and be thankful for:

1)  Our Brain Uses Two Systems: System 1 and System 2

• System 1 is fast, intuitive, emotional, and responsible for quick judgment & automatic decisions. It is prone to biases and errors such as overconfidence.

• System 2 is slow, analytical, deliberate, conscious, and more rational. It is necessary for complex tasks & reasoning, requiring focused attention.

Recognize the signs that you are a more cognitive minefield. Be aware of when you might be prone to making mistakes due to cognitive biases or faulty reasoning. The fast part makes quick decisions, while the slow part thinks things through.

 

2) Irrationality

Humans are not rational. We all make a lot of irrational mistakes.

• 90% of Americans think they can drive better than average and 70% think they are smarter than average.

• An investor might hold onto a losing stock with the belief that it will eventually rebound, despite evidence suggesting otherwise.

 

3) Prospect Theory

People value gains and losses differently, leading to inconsistent decision-making.

• Many people don't want to play a Heads or Tails game where they can win $100 but risk losing $50. You should take this bet every single day.

• An investor might panic and sell off stocks during a market downturn, fearing further losses, even though a more rational approach would be to hold onto them or even buy more at discounted prices.

4) Loss Aversion

Suggests that people feel losses twice as hard as gains.

• Why does the loss of $100 hurt about twice as much as the gain of $100 brings pleasure? We often feel the pain of losing money more than the joy of gaining it.

5) The Halo Effect

The halo effect is a cognitive bias where your overall impression of a person influences your perception of their individual traits or qualities.

• If you like someone, you'll overestimate their capabilities and vice versa. Our first impression of something can affect how we see it.

• Investors might disproportionately trust the recommendations or advice of a financial influencer simply because they have a positive impression of them, without critically evaluating the advice itself.

6) Availability Heuristic

The availability heuristic is a cognitive bias where you judge the likelihood of an event based on how easily it comes to mind.

• If something bad just happened, we might be too scared to take risks. A good example is 9/11 which made people afraid of flying.

• Investors might avoid investing in certain sectors or asset classes because of recent negative news headlines, even if the long-term fundamentals suggest they are sound investments.

7) Sunk Cost Fallacy

The sunk cost fallacy appears when you keep investing in something even if it's not worth it, simply because you've already invested resources in it.

• Even if it's not worth it, we hate to admit we made a mistake. Think about choosing to finish a boring movie because you already paid for the ticket.

• An investor might continue to hold onto a poorly performing investment because they've already invested a significant amount of money into it, even though selling it would be the rational choice.

8) Confirmation Bias

People tend to seek out information that confirms their existing beliefs and ignore information that contradicts it.

• Investors might only seek out news or analysis that confirms their preexisting beliefs about a certain stock or market trend, ignoring contradictory information that could challenge their views.

• We ignore anything that doesn't fit our ideas. As an investor, always talk with people who have opposing views. It will be very insightful.

9) Hindsight Bias

The tendency, after an event has occurred, to believe that one would have predicted or expected the outcome.

• A good example is that after attending a baseball game, you might insist that you knew that the winning team was going to win beforehand.

• After a stock experiences a significant price increase, investors may claim they knew it would happen all along, attributing their success to skill rather than luck.

10) Framing Effect

When the way information is presented influences your decisions and perceptions, we call it a framing effect.

• Studies have shown that “75% lean meat” is usually preferred over “25% fat meat”, even though it's the same thing.

• A company announces its quarterly earnings in two ways: “The company reports that it missed its earnings target by 10%” or “The company reports that it achieved 90% of its earnings target”. Even though both statements convey the same information, the first framing might lead investors to perceive the company in a more negative light, while the second framing might be perceived as more positive, potentially affecting investors' decisions regarding buying or selling the company's stock.

11) Anchoring Effect

The anchoring effect is a bias where you rely too heavily on the first piece of information you receive when making a decision.

• If you first see a car that costs $100k and then see a second one that costs $70k, you tend to see the second car as cheap.

• If a person is exposed to a high price for an item first, they might be willing to pay more for it if they were exposed to a lower price initially.

• Investors might anchor their expectations for future returns based on past performance, leading them to overestimate potential gains or underestimate risks.

12) Overconfidence

The tendency of people to be overly confident in their own abilities and judgments, even when evidence suggests they should be more cautious. This overconfidence can lead to poor decision-making as people may take unnecessary risks or overlook important information.

• A trader, overestimating their ability to predict short-term market movements, might engage in excessive trading activity driven by unwarranted confidence, resulting in increased transaction costs and suboptimal returns compared to a more passive approach.

 

Daniel Kahneman's work reminds us to be careful with our money and how we think about it. We should be grateful for his insights and learn from them to make better financial decisions.

Among its myriad implications, it's foolish to check one’s stock portfolio frequently, since the predominance of pain experienced in the stock market will most likely lead to excessive and possibly self-defeating caution.

     

                                                                 

(Courtesy: TOI)