I’m looking forward to December 6, 2016, publication of Michael Lewis’s next book The Undoing Project: A Friendship that Changed Our Minds about the partnership of Daniel Kahneman and Amos Tversky.
Several years ago, I heard Dr. Kahneman deliver one of the most memorable lectures I have ever attended. For his work on the psychology of judgment and decision-making, as well as behavioral economics, Kahneman was awarded the 2002 Nobel Memorial Prize in Economic Sciences. His work challenges the assumption of human rationality prevailing in modern economic theory. With Tversky and others, Kahneman established a cognitive basis for common human errors that arise from heuristics and biases and developed prospect theory.
In a recent podcast, Kahneman discusses how he met Amos Tversky and how they researched cognitive biases and heuristics. He also summarizes the six cognitive biases that affect both our everyday lives and our investing outcomes. Here are a few excerpts from the Masters in Business interview, but I hope you listen to the entire discussion.
1. Attribute Substitution occurs when an individual makes a judgment that is computationally complex, but substitutes a more easily calculated heuristic attribute.
Dr. Kahneman: “You ask someone a complicated question, like: What is the probability of an event? And they can’t answer it because it’s very difficult. But there are easier questions that are related to that one that they can answer. Such as: Is this a surprising event? That is something that people know right away. So what happens is people take the answer to the easy question, they use it to answer the difficult question, and they think they have answered the difficult question. But in fact they haven’t — they’ve answered an easier one.”
2. Availability heuristic is a mental shortcut that relies on immediate examples that come to mind when evaluating a specific topic, concept, method or decision.
Dr. Kahneman: “People are really not aware of information that they don’t have. The idea is that you take whatever information you have and you make the best story possible out of that information. And the information you don’t have — you don’t feel that it’s necessary. I have an example that I think brings that out: I tell you about a national leader and that she is intelligent and firm. Now do you have an impression already whether she’s a good leader or a bad leader? You certainly do. She’s a good leader. But the third word that I was about to say is ‘corrupt.’ The point being that you don’t wait for information that you didn’t have. You formed an impression as we were going from the information that you did have.”
3. Anchoring Bias describes the common human tendency to rely too heavily on the first piece of information offered when making decisions.
Dr. Kahneman: “In the example of negotiation, many people think that you have an advantage if you go second. But actually the advantage is going first. And the reason is in something about the way the mind works. The mind tries to make sense out of whatever you put before it. So this built-in tendency that we have of trying to make sense of everything that we encounter, that is a mechanism for anchoring.”
4. Loss Aversion refers to people’s tendency to prefer avoiding losses to acquiring equivalent gains.
Dr. Kahneman: “Losses loom larger than gains. And we have a pretty good idea of by how much they loom larger than gains, and it’s by about 2-to-1. An example is: I’ll offer you a gamble on the toss of a coin. If it shows tails, you lose $100. And if it shows heads, you win X. What would X have to be for that gamble to become really attractive to you? Most people — and this has been well established — demand more than $200. Meaning it takes $200 of potential gain to compensate for $100 of potential loss when the chances of the two are equal. So that’s loss aversion. It turns out that loss aversion has enormous consequences. This is evolutionary. You would imagine in evolution that threats are more important than opportunities. And so it’s a very general phenomenon that bad things sort of preempt or are stronger than good things in our experience. So loss aversion is a special case of something much broader.”
5. Narrow Framing refers to the context in which a decision is made, or the context in which a decision is placed in order to influence that decision.
Dr. Kahneman: “People view the situation narrowly. And that is true in all domains. So for example, we say that people are myopic — that they have a narrow time horizon. To be more rational, you want to look further in time, and then you’ll make better decisions. If you’re thinking of where you will be a long time from now, it’s completely different from thinking about how will I feel tomorrow if I make this bet and I lose.”
6. Hindsight Bias refers to the fact that you have accepted a theory and it is extraordinarily difficult to notice its flaws. Also, after an event has occurred, we are inclined to view the event as having been predictable.
Dr. Kahneman: “Hindsight is a big deal. It allows us to keep a coherent view of the world, it blinds us to surprises, it prevents us from learning the right thing, it allows us to learn the wrong thing — that is whenever we’re surprised by something, even if we do admit that we’ve made a mistake or [you say] ‘I’ll never make that mistake again.’ In fact, what you should learn when you make a mistake because you did not anticipate something is that the world is difficult to anticipate. That’s the correct lesson to learn from surprises — that the world is surprising.”
Next week, I’ll apply these behavioral finance tenets to how we manage investments. Stay tuned.