In this week’s edition of Insights, we delve into the invaluable lessons left by the late Nobel Laureate, Daniel Kahneman. His ground-breaking contributions to behavioural economics have become a cornerstone of our investment philosophy and approach to guiding investors towards favourable outcomes.
Daniel Kahneman, the Israeli-American psychologist whose death was recently announced, was one of the pioneers of behavioural economics.
Kahneman, a professor at Princeton University, became the first non-economist to be awarded the Nobel Prize in Economic Sciences in 2002, in what was a watershed moment for academic finance. The award officially recognised the critical part played by human behaviour and decision-making in investment outcomes.
What, then, can investors learn from Daniel Kahneman’s work?
Here are six important lessons from his book, Thinking, Fast and Slow, published in 2011, which has sold more than ten million copies worldwide.
1. Don’t be a lazy thinker
A key message of Thinking, Fast and Slow is that the human brain has two interrelated systems that create “systematic errors in thinking”.
System 1 is fast, automatic, emotional, and subconscious. It involves intuitive, quick judgments and decisions without deliberate analysis. System 2 is slow, effortful, logical, and conscious. It is responsible for deliberate thought processes, such as solving complex problems or making decisions that require careful consideration.
The problem with System 2 is that it involves more effort, and because, as Kahneman puts it, “laziness is built deep into our nature,” we can struggle to focus and think critically.
Because investment decisions have a big impact on our long-term financial security, we need to apply System 2 thinking when making them. That requires us to put in time and effort, and avoid acting on our instincts or emotions, or on mental shortcuts.
2. Accept that you are biased
Another central message contained in Kahneman’s book is that, as human beings, we’re all prone to a range of behavioural biases that can get in the way of rational decision-making.
Not only that, we also have behavioural blind spots. In other words, we’re much better at identifying biases in other people than in ourselves.
“We are blind to our blindness,” Kahneman wrote. “We have very little idea of how little we know. We’re not designed to know how little we know.”
Successful investing requires us to acknowledge the different biases we suffer from, and to be mindful of those biases when making decisions, particularly when we feel under pressure. Ideally, we should have a financial adviser, or at least a trusted friend, who can act as a behavioural coach.
3. Know your limitations
There is one behavioural flaw in particular that Daniel Kahneman warned we should guard against — overconfidence.
Humans have a tendency to be overconfident about all sorts of things. Most people, for instance, consider themselves above-average drivers. It’s a trait that serves us well in many areas of life, but it can be a curse in others, and investing is a prime example.
If we think we know more than we actually do, we’re tempted to make predictions about the future, or to base our investment strategy on the predictions of people we consider to be experts.
“Overconfidence is a bias rooted in the systematic errors that we make when we try to predict the future,” Kahneman explained. “It is fed by the illusion of understanding, the illusion that we understand the past, which implies that the future is also predictable.”
The answer is to recognise overconfidence in ourselves and other people, including financial advisers and fund managers. We should avoid making concentrated bets on particular countries, sectors or stocks, and diversify our investments instead.
4. Learn to zoom out
One of the most quoted insights from Kahneman’s book is this one: “Nothing in life is as important as you think it is, while you are thinking about it.” Simply put, the human brain has evolved to make us finely attuned to recent and current events.
“People tend to assess the relative importance of issues by the ease with which they are retrieved from memory,” Kahneman wrote, “and this is largely determined by the extent of coverage in the media.” So, for example, we read in the news about a plane crash or shark attack, and then avoid flying or swimming in the sea.
Psychologists refer to this tendency as availability bias, and it’s a big problem in investing. For instance, people feel much less inclined to invest after a major market crash, even though it may actually be a very good time to invest. They are more likely, though, to invest in a company if it’s a big brand that they’re very familiar with, or if they’ve read about the stock in the weekend press.
It’s important for investors to zoom out and see the bigger picture. Instead of focusing on what’s happening in the markets today, have an appreciation of financial history, and remember that whatever it is that’s bothering you now you may not even remember in a few years’ time.
5. Look for contradictory evidence
Another bias that Daniel Kahneman warned against is confirmation bias. This is the tendency to search for and favour information that confirms our pre-existing beliefs.
“The bias to believe and confirm is stronger than the bias to doubt and disconfirm,” he wrote, “which is why false beliefs are difficult to correct. Confirmation bias is the most significant of the cognitive biases.”
Investors are guilty of this mistake all the time. So, for instance, they decide they want to buy a particular stock and fund, and then go out and find information that supports that decision.
They should really be doing the opposite. If you think you’d like to buy or sell a particular asset, speak to your adviser or a friend and ask them to act as devil’s advocate and give you reasons why you shouldn’t buy or sell it.
Also, never act on an investment tip you read in a newspaper or hear about on a TV channel like CNBC. Make a habit of reading the opinions of people who will put an alternative point of view.
6. Get comfortable with uncertainty
A recurring theme in Thinking, Fast and Slow is uncertainty. The future, Kahneman said, is fundamentally unpredictable, and yet, our brains have evolved to make us crave a degree of certainty and control. We want the world to make sense.
Kahneman refers to this as the illusion of understanding, and one of the main reasons for it, he says, is hindsight bias, or assuming that events that happened in the past were predictable.
“The idea that the future is unpredictable is undermined every day by the ease with which the past is explained,” he wrote. One example he gives is the global financial crisis of 2008. People look back on that episode now and see it as something that was bound to happen. Yet there were many highly intelligent commentators at the time for whom it came as a complete surprise.
The answer to the illusion of understanding is to know what you don’t know, and to acknowledge what Kahneman called “our almost unlimited ability to ignore our ignorance”.
From an investment perspective, all known information about stocks and bonds is already baked into the price. The only thing that causes prices to move, either up or down, is new information, and that, by definition, is unknowable. So learn to get comfortable with uncertainty and ambiguity.
Beware the illusion of skill
Although he generally refrained from discussing implementation of specific investment strategies, Daniel Kahneman did occasionally caution investors against using actively managed funds. Stock-picking and market timing skill, he said, are mostly illusory.
In a podcast interview for the CFA Institute in 2018, for example, Kahneman said this: “All behavioural economists are against active investing — I might as well say it outright — because we think the market is unpredictable, or very, very difficult to predict. And yet we believe people who believe they can predict the market. That illusion is very important.”
So, spreading your risk across a broadly diversified portfolio of low-cost index funds is an excellent starting point for anyone looking to apply Kahneman’s insights to their investing.
Always use a systematic approach to investment decisions that includes checking for biases. Actively look for information that contradicts your beliefs to ensure a well-rounded view. And stay focussed on your long-term goals rather than reacting to short-term market fluctuations.
Reason and discipline will almost certainly produce better results than acting on instincts and emotions in the long run.