Daniel Kahneman-My Favorite Economist

April 10, 2024

Nobel Prize winner in Economics Daniel Kahneman passed away two weeks ago at age 90. Interestingly, he never took an economics class, he was a PhD in Psychology. When I took Econ 101 in the “Dark Ages” the established theory in economics was that people made rational decisions with their money. Dr. Kahneman blew that theory to pieces. He introduced the concept of Homo Sapiens, recognizing the human tendency towards irrationality and emotional decision-making. He helped create behavioral finance, which acknowledges that investors are not always rational actors and how cognitive biases impact our financial decisions.

In his memory, here are some of Dr. Kahneman’s significant findings, many of them with Amos Tversky, that we see and help clients overcome in our work every day here at DWM:

Loss aversion. People feel pain twice as much as the pleasure of gain. Why does the loss of $100 hurt about twice as much as the gaining of $100 brings pleasure? Why did some investors start to panic in 2022 when the S&P 500 goes down 25% after going up 200% over the prior 12 years? Why do golfers putt better on a par putt (which if missed results in a bogey) than a stroke-gaining birdie?

Dual-process theory of the mind. Kahneman published his best-seller “Thinking, Fast and Slow” in 2011. It suggests that human thought can be divided into two types: fast and slow. Fast is intuitive and emotional. Slower is more deliberate and logical. Obviously, more important decisions need to use the slow process.

Cognitive Biases.

a.  The “Recency bias” is the tendency to think that what is happening lately will keep happening.

b.  The “Anchoring bias” is when you get fixated on a prior value, like the stock market at 12/31/21, when markets had just hit all-time highs.

c.  Cycle of Investor Emotions. The emotional investor tends to buy high and sell low. See below:

Overconfidence. Intuition can lead us astray. Dr. Kahneman would say: “People jump to statistical conclusions often on the basis of very weak evidence. We form powerful intuitions on inadequate information.” He also said that many people take more credit than they should. Dr. Kahneman insisted that, after studying the foibles of the human mind, he wasn’t any better at problem-solving than anybody else. Instead, he credited only part of his success to hard work-but even more to luck, especially meeting his lifetime business collaborator Amos Tversky.

Look at the “Base Rate.” Kahneman felt the most important question to ask before making a decision was to look at the base rate. This is the “the objective odds of success, given the historical range of outcomes in similar situations.” If you are thinking of starting a business, look at how successful/unsuccessful new businesses are. Half of them fail within the first five years. So, a 50/50 base rate wouldn’t tell you not to start the business, but would encourage you from being unrealistically optimistic. Similarly, before Dr. Kahneman proposed to his wife he said to her: “I’m Jewish, you’re not. I’m neurotic, you’re not. Half of marriages end in divorce. The base rates are against us. She replied, “Oh, who cares about base rates!” Their marriage lasted four decades until her death.

Jason Zweig, financial journalist at the WSJ, worked on a number of projects with Dr. Kahneman and summarized some key personal characteristics of his life-long friend:

  1. “Danny” saw everything through a child’s mind. He never assumed anything was valid, but questioned everything- does it make sense?
  2. Kahneman was relentlessly self-critical. He was very smart and loved to be questioned-from readers or seminar participants. He wanted to know where he was wrong.
  3. Professor Kahneman could rework what he had done earlier as it never existed. He liked nothing better than to change his mind when the evidence justified it. “I have no sunk costs,” he would say.

Dr. Kahneman kept most of his money in low-cost, diversified index funds. He didn’t try to outsmart the market. He often said, “All of us would be better investors, if we just made fewer decisions.” He was a very smart and special man.

In conclusion, Dr. Daniel Kahneman has had a profound impact on me, DWM and other informed wealth managers who emphasize psychologically informed approaches to wealth management. When it comes to decisions about money- think slow, not fast and don’t take action before you discuss it with your wealth management coach at DWM.

Detterbeck Wealth Management is a fee-only financial planning / wealth management company with offices located in Palatine, IL (Chicago area) and Charleston, SC areas serving clients locally and across the country. To contact us about setting up an appointment, please see our contact us page