The recent passing of behavioural economist Daniel Kahneman reminded me of the great insights I gained from reading Michael Lewis’s The Undoing Project, the story of the friendship and collaboration between Amos Tversky and Kahneman.
They founded much of the field of behavioural economics, which contrasts with traditional economic theory by reminding us that all decision-making risks our human frailties.
Our quirks and oddities make sure that even if we have studied ourselves to the level of “expert”, these biases (whether instinctive or learnt) are in the background, waiting to trip us up if we are careless.
As is the case with most financial celebrities (of whom Warren Buffett is probably the chief poster boy) their words are often poorly quoted or thinly adapted to whatever the sales pitch of the day is. Their research was both groundbreaking and deeply insightful, and I strongly suggest that serious students of markets obtain detailed examples of their work to appreciate them fully.
I have often felt that what the inspiration for successful people is very informative, and Lewis’s book explains how Kahneman’s army experience shaped the future direction of his thinking.
Trained as a psychologist, Kahneman’s initial task was to profile candidates for officer training. He described how a multitude of tests were created, with apparently logical bases, only for it to be found on implementation that the tests were hopeless as predictions of the performance of candidate officers. He realised that one of the problems was that the traditional method of interview led the interviewer to latch on to a personal attribute they liked and then form favourable opinions about other attributes as interviews proceeded (a so-called halo effect).
Kahneman realised that stereotypes were useless. His redesigned interview process, which stripped out halo-type prejudices, was subsequently successful in identifying not only people who’d be successful as officers, but also those who would succeed in most jobs.
One quirky moment was when he debunked the method of criticising air force pilot trainers. It had been decided that pilots who were praised for a good session tended to perform badly the next time, whereas those who were scolded for a bad session tended to perform well next time. Thus praise was not preferred. After observing, Kahneman pointed out the trainers were, in fact, responding to a form of mean reversion, as pilots were likely to perform in a more average fashion after especially good or bad sessions.
Tversky and Kahneman loved creating and running experiments and studies that would uncover the systematic biases and irrationality that people deploy in their judgments and decision-making. These tests can be maddening because they are so in-your-face.
Kahneman’s redesigned interview process ... was subsequently able to identify not only people who’d be successful as officers but also those who would succeed in most jobs
One of their core developments was the prospect theory, which contradicted classical economic assumptions about how individuals make decisions under conditions of uncertainty.
Traditional economic models assume that people are rational utility maximisers, but the prospect theory notes that individuals often deviate from rationality in predictable ways when evaluating risky choices. The theory says that people’s attitudes towards risk are shaped by the potential gains and losses relative to a reference point, rather than by the averaged outcome.
Also, people can be risk averse when facing gains but become gamblers when facing losses of the same size. This asymmetry in risk perception, known as the “loss aversion” principle, highlights the impact of psychology on economic decision-making.
Tversky and Kahneman uncovered loads of cognitive biases that pollute human judgment and decision-making. One is the “anchoring effect” where people allow initial (and often pointless) information (anchors) to influence making subsequent judgments. This tendency to anchor on irrelevant information can lead to systematic errors in decision-making.
Their work dug deep into the role of heuristics (mental shortcuts or rules of thumb) in guiding how people make decisions in uncertainty. While heuristics often provided efficient solutions to complex problems in our caveman days, they can be very dodgy when applied into our much more complex modern society.
The “availability heuristic” demonstrates how people assess the likelihood of an event based on its ease of recall from memory. Events that are more vivid or recent tend to be overestimated in frequency, regardless of their actual probability.
The “representativeness heuristic” describes how individuals judge the likelihood of an event based on how closely it resembles a prototype or stereotype. This particular notion is how people will allow themselves to be deceived by preconceived ideas.
Traders and investors — read more to know thyself!
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