What was I thinking?

 

Perhaps you have asked yourself this rhetorical question at some stage while pondering the results of a poorly conceived investment decision. Daniel Kahneman would have been able to provide insight around this question for you.

 

Kahneman, who died last week at the age of 90, would have explained to you that as humans, we can show a tendency to abandon logic and rely too much on recent events, effectively finding cognitive effort to be unpleasant and abandoning this at our own peril. Stated another way and more specifically, his work was recognized for “having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty”.

 

This is all particularly relevant to investment decision making and since this is an investment and wealth focused blog, lets unpack this a little further…

 

Committing himself to decades of work in this field, Kahneman authored numerous papers and books often demonstrating relevance in the relationship between psychology and economics. He earned global acclaim, had been a frequent speaker at the World Economic Forum in Davos and earned numerous awards including the 2002 Nobel Peace Prize in Economic Sciences for his contributions to behavioural economics. The quote above was a part of how his professional contribution was defined at this presentation.

 

A few examples of the research and insight that Kahneman (often times together with his long-time collaborator Amos Tversky) left us with are following, 

• Loss Aversion Theory (aka Prospect Theory) - the experience of loss holds twice as much impact as that of a gain. In a telling study, participants determined that a winning flip of a coin must pay out $200 or more if a losing coin-toss were to result in a loss of $100. Losses are painful and while inevitable within a diversified portfolio, the key is to limit further losses by way of rational, forward looking decision making.
  • Thoroughly and thoughtfully dealing with the experience of losses separates successful investors from those that are not.
• From his book Thinking, Fast and Slow, Kahneman distinguishes between two thought processes. The first (system 1) reacts quickly and relies on emotion and intuition with which to make decisions. The second (system 2) is a slower moving, rational and analytical process and which helps to correct errors made in system 1.
  • Applying system 2 functionality is an absolute necessity for investment success, and which overcomes the biases present in system 1 thinking, which happens to be where most people make decisions.
• ‘Experiencing-self’ and ‘Remembering-self’; each reside within all of us as individuals. The experiencing-self lives in the present and knows only this moment. The remembering-self is the keeper of the scrapbook, acting as a storyteller which can guide future decisions and the anticipated memory which may come (or, which may not).
  • Making investment decisions requires a clear understanding of one’s own feelings about risks – reconciling the remembering-self with the experience-self and determining an unbiased, objective view on one’s own risk tolerance is not a simple task. This leads us to a comment made by Kahneman with regards to important decisions; “it is best to get advice from someone who likes you but doesn’t care much about your feelings.”

Daniel Kahneman’s contribution to the world of psychology and economics is immeasurable.

 

Fortunately for all of us, including investors and their advisors, his work will continue to help prompt better decision making which ultimately leads to more successful results, in investing and in all aspects of life,