Behavioural economics Daniel Kahneman transformed our thinking, writes Tim Mackay.
Despite winning a Nobel Prize in economics, Daniel Kahneman was an unlikely economist. For one, he never undertook a single course in economics. For another, he was a psychologist. His body of research is vast and multifaceted, but at its core it challenged conventional wisdom on how we make investing decisions.
With Amos Tversky, Kahneman was the pioneer of behavioural economics and is well known for debunking the idea that people always make rational decisions in their own self-interest.
Kahneman died on March 27 at the age of 90 after transforming our understanding of investing. His research shows the intersection of personal finance and psychology is far more ‘‘personal’’ than it is financial. Here are some of his critical discoveries for investors.
Kahneman’s greatest insight was that investors make mistakes, which sounds obvious. But his groundbreaking realisation was that our mistakes are the norm, not the exception.
We rush to judgment using mental shortcuts (or heuristics), leading to persistent biases in our decisions. Even when evidence suggests we ought to rethink, we often cling to our initial judgments.
None of us like being wrong. But once you accept mistakes are inevitable, you can seek to understand them and become a better investor.
Kahneman found we hate losing money far more than we enjoy gaining it. Losing $100 hurts twice as much as the pleasure from gaining $100. It has been shown golfers play better when putting for par (fearing the ‘‘loss’’ of a bogie) than when putting for the ‘‘gain’’ of a birdie.
As humans evolved, threats were always far more consequential than opportunities. If you spotted a deer, it could feed you for a few days. But if you spotted a lion, it could end everything.
Our objective as investors is to gain returns, but our behaviour is driven more by fear of loss. We tend to prematurely sell assets that are gaining value and retain assets that are losing money. We desperately want our losers to win. One solution is to accept you will win a few and lose a few, but it’s the overall portfolio performance that really matters.
Avoid looking at your portfolio too often. A ‘‘loss’’ each day for a week could still be a ‘‘gain’’ over a month. When you look more often, you trade more, and you lose more money.
A study revealed 74 per cent of professional fund managers think they are above average. The other 26 per cent thought they were average. Mathematically, this is impossible – half must be below average.
Kahneman believed this was our key bias. ‘‘What would I eliminate if I had a magic wand? Overconfidence,’’ he said.
The vast array of financial information available online creates the illusion of understanding. This leads to excessive trading, timing the market, under-diversification and risky investments.
When we research investments, we typically seek out and value more highly any information that supports our existing view. And we downplay information that calls it into doubt. .
Seek objective feedback, diverse and contrary opinions and stick to an objective re-balancing plan.
Kahneman and Tversky provided important insights into ‘‘anchoring bias’’ and the ‘‘endowment effect’’.
Anchoring bias describes the fact that investors rely too heavily on the initial opinion or piece of information they are given on any topic. Imagine you were told a widget sells for between $85 and $100 but is available for $75. You might view this as a good deal.
However, if you were simply told a widget costs $75, you’d be far more likely to ask: what is a widget? And you’d question its true value. The deliberate ‘‘anchor’’ placed first in the information you are given distorts your analysis and is a common pitfall in financial decision-making.
The endowment effect is a term coined by Richard Thaler, and in a 1991 study, Kahneman and colleagues proposed that it occurs, in part, due to loss aversion. When we own something – such as a BHP share – we give it more value than it might objectively hold. This leads to a paradox where we are more likely to keep a BHP share we own rather than acquiring one we don’t, despite the result being the same in both scenarios – ownership of the share.
This cognitive bias skews our perception, often preventing us from selling assets when it might be prudent to do so, as we overestimate their worth due to personal ownership. SI
Tim Mackay is an independent financial adviser at Quantum Financial.