Prof. Daniel Kahneman. Photograph by Princeton University, John J. Jameson.
A hardy appreciation of irrationality is a prized trait among some of the best investors. Those who saw the threat of the housing bubble before the 2008 market crash can back up that assertion.
And they can thank Daniel Kahneman, who built his academic career and won the Nobel Prize for economics in 2002 on the insight that, contrary to the long-held belief that investors were rational beings, they often are not.
The branch of economics he helped found, behaviorism, charted the many ways people, in general, and investors, in particular, get their thinking warped by emotional reactions, mental shortcuts and other acts not in their own self-interest.
A Ph.D. in psychology who had never taken an economics course, Kahneman died on Wednesday at 90, leaving a big legacy in economics. He sometimes is known as “the father of behaviorism,” a label he dismissed. Kahneman, who taught at Princeton University, already had developed theories about behavioral pitfalls early in his academic career, but his friendship with an economist, Richard Thaler, who won a Nobel Prize in economics in 2017, helped him shift his focus to economics.
Along with Thaler (based at the University of Chicago) and another professor, the late Amos Tversky (Stanford University), Kahneman developed many theories about poor judgment. One was called “judgmental heuristics,” about the common practice of taking mental shortcuts, which acts to save time but also can lead people astray. Example: learning to beware of slick-talking financial hustlers like Bernard Madoff could lead you to stay out of the stock market entirely.
Kahneman came to wider public notice with his 2011 best-selling book, “Thinking Fast and Slow,” about a duality in human behavior. Thinking fast is emotional and instinctive; thinking slow is more logical and deliberate. The book covered some of his theories, such as “sunk cost,” in which people keep pouring money into an investment even though it is clear the endeavor was a loser.
Behavioral biases are omnipresent, Kahneman wrote—and other research has shown they even effect pension decisionmaking. A 2017 paper by four British academics (three of them in psychology, one in finance) concluded that pension boards of trustees, are deficient in financial know-how, and thus make decisions that are often removed from pure rationality, as Kahneman outlined. Board members let other influences sway them, the paper stated, and so they “have an illusion of effectiveness.”
Kahneman and behaviorism have had widespread influence, including in the world of retirement planning. For instance, Thaler and a younger behavioral economist, Schlomo Benartzi, formerly at the University of California, Los Angeles, two decades ago formulated payroll savings plans that feature auto-enrollment, which overcome employees’ inertia about signing up. These are used broadly now throughout corporate America.
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Tags: Amos Tversky, behaviorism, Bernard Madoff, Daniel Kahneman, economics, housing bubble, Richard Thaler, sunk cost