Unless you have a deep interest in economics and investing, the death of Daniel Kahneman in March at the age of 90 may have slipped your notice. In Acuvest, we have a deep interest in these topics, and so Kahneman’s death brought about a period of reflection of how the work he did through his life touched all our lives from afar.

Kahneman was a psychologist who was awarded the Nobel Prize in Economics in 2002 for his work on behavioural economics. His research on decision-making, judgement and cognitive biases had a significant impact on the world of economics, finance and our understanding of the way in which people make investment decisions. Ultimately being aware of the impact of emotions and how people react to them can help us to make better decisions in relation to our finances and our lives. He also released a highly successful book in 2011 called Thinking, Fast and Slow, which explored the way in which intuition (fast) and deliberate & logical analysis (slow) shape our choices and perceptions.

While we can’t do justice through a single article to his published works or the many articles written about him, as we discussed his death in the office, we felt his main teachings merit sharing with you.

The key biases

While we are now aware of many behavioural biases that impact the way we perceive the world and make decisions, two of the key biases that Kahneman’s work centred on were the fact that people are very loss averse, but they are also very optimistic. What this means is that:

  • We feel the pain of loss more acutely than the joy of gains – he estimated this to be almost twice as much. This potentially has quite an impact on the investment decisions we make, and how we react to market changes, with a fear of losing money sometimes being an overly dominant emotion.
  • We also overestimate our chances of success, so we don’t realise how bad the odds of success are and potentially take a higher degree of risk in our decisions than we would be comfortable with, if we were better able to judge the likely outcomes. Kahneman was quoted as saying that “Optimism is the engine of capitalism, but overconfidence is a curse”. He wasn’t blind to the fact of it being a blessing in some instances, as most of the big success stories that fuel optimism were achieved by people that you could argue were overconfident of their chances of success.

Don’t underestimate randomness

Another theme that he was very big on was that people underestimate the amount of randomness (what he often called noise) that exists in the world. The saying that hindsight is 20-20 vision is a perfect example of this. We often believe that when something has happened, it appears obvious why things didn’t work out fully as expected. This leads people to believe that they have learned something about cause and effect, and that you will be able to apply this learning to better predict future outcomes.

Kahneman, however, suggested that these conclusions are usually wrong. Rather than thinking we have learned about cause and effect, we should be learning that we were surprised again, and that the world is more uncertain than we think.

The reason I think this is so interesting is that when trying to help people to manage their investments, we are working in a world of financial markets where there is an incredible amount of noise. In developing expectations to inform investment advice, and then in providing advice to people, as an advisor I need to be very aware of my own biases, and the biases that my clients might also have.  I can’t say it is easy, but it is definitely interesting!

Kahneman’s strategies

Kahneman proposed that we follow four simple strategies for better decision making in finance and life:

  1. Don’t Trust People, Trust Algorithms

Kahneman said that “Algorithms beat individuals about half the time, and they match individuals about half the time.” Basically, algorithms / process almost always trumps the supposed expertise / genius of people, over the long term. At Acuvest, we really subscribe to this and cannot emphasise enough the important of having a disciplined process that is anchored in a client’s personal objectives. Having a rules-based approach is an effort to remove the emotion from the decision-making framework and provides a broad context to help frame a client’s individual investment decisions, both in the planning and reacting (ongoing management) stages.

  1. Take the Broad View

We believe it is critical to start financial planning and to incorporate decisions in the context of a client’s overall objectives by thinking about what they are trying to achieve, why and over what timeframe. This gives a long-term & broad framework. We then try to use a disciplined process to develop the client’s investment strategy and to frame all decisions as broadly as possible.

We also know that very few people can predict what is going to happen to individual companies, or markets, or even to choose the managers that can. As a result, we tend to advise clients to think long-term when constructing their portfolios, and, in many cases, use passive investment vehicles to get access to the entire market. We are strong believers in the benefits of having a disciplined process of reviewing investment objectives & rebalancing portfolios, to overcome anchoring bias to keep things as they are, and the endowment effect that persuades us to hang onto winners (or losers) that we own.

  1. Test for Regret

The risk of regret is one of the biggest obstacles to effective decision making as it promotes inaction. To guard against this, investors need to understand what they are invested in and how it might perform if things go well. They also need to recognise what might happen and what they might do if markets deliver some bad outcomes (whether expected or not). This should help to avoid regret risk, which tends to be at its highest just after things have gone unexpectedly well – but you have missed out on them, or when things have gone badly – and you have suffered a loss you weren’t fully prepared for the possibility of (or the impact it might have on your state of mind).

As your advisor, we place a lot of focus on managing investor expectations & helping clients to remember the original time horizon. We remind them that dips in the market are good news for people looking to buy, and unless they are likely to be permanent, are largely irrelevant to people who are planning to hold rather than sell investments.

  1. Seek out Good Advice

Kahneman believed that good advice was essential for investors who are serious about achieving the outcomes they want. When presenting at a CFA seminar a number of years ago, he was asked how to achieve happiness. He summed up his thinking in these areas as follows,

  • If you have a problem in life, seek advice.
  • Don’t make important decisions in life without seeking advice.
  • Ask advice from someone who likes you but does not care about your feelings. Make sure the person will not respond with emotion clouding their advice. That person will not have loss aversion risk for you, and so they are more likely to give you good advice.

Thank you Daniel Kahneman, may you Rest in Peace, and may we all learn to be wiser.

Image licenced under Creative Commons – NRKbeta.no