by Daniel KAHNEMAN,

2002 Nobel Laureate in Economic Science and Psychologist


The Cost of Ideas

The main difference between economics and behavioural economics and between finance and behavioural finance are the assumptions that are made at the basis of the theory. There are two main assumptions: one is that people are rational and the other is that people are selfish. Psychologically, both of these assumptions make very little sense, and that is really the origin of behavioural finance and behavioural economics.

There are economic agents who make large and predictable mistakes. For example, individuals who invest on their own characteristically make large and expensive mistakes. If we analyse individual transaction in which an individual investor bought a stock and sold another in a single day, it is safe to assume this transaction is not based on liquidity. What determines the individual’s behaviour is the belief that one stock will outperform the other. Now with modern technology we can easily analyse the outcomes of this single-day transaction a year later, and the results are quite astonishing. On average, the stock that a person sold did better than the stock they bought, but it’s not only that it did better — it did better by a large amount. The average is 3.4 percent. These results have been replicated many times over.

This phenomenon leads to a very simple notion: there is an average cost of having an idea for an investor, and the average cost is about 3 percent, which is quite a lot. So, having ideas cost people money, and people have lots of ideas. Individual investors tend to churn their accounts, they tend to trade too much, and that they trade too much seems to be due over-confidence. They believe they know something that they do not know and this is one essential characteristic of human beings, which makes them different from rational beings.

Research shows that as individual investors, women do better than men. The reason is quite simple: It is not that they have fewer costly ideas. Indeed, they may have as many ideas, but they act on these ideas less. They trade less, and by trading less, they achieve significantly better results than many investors. So, that is just one main example of what happens to individual investors on the market. Clearly, there are people on the other side of these transactions. The other people are professionals – not that the professionals know so much, but the professionals clearly know better than the individual investors and clearly take advantage of them. It is because the market consists both of professionals and individuals that, in these days of computers, it is quite difficult to make money from psychological assumptions.

 

Confidence & Expertise

Can you develop expertise in picking stocks? This is very doubtful. In fact, it is probably not the case, because it is such a highly irregular environment.

Important aspects of the psychology of investors and of decision-makers in general are confidence and expertise. What is the origin of confidence? Most of the time, we feel considerable confidence in our opinions and our beliefs. In fact, we are generally over-confident. According to research, this is what causes excessive trading and it clearly causes a lot of trading in general. This is key – and psychological research is fairly unequivocal on the matter. Confidence is not a very good indicator of accuracy. You can have confidence in opinions that are not accurate at all. Confidence is primarily a feeling, and it is the feeling of coherence of the story that you are telling yourself. If the story that you are telling yourself makes sense, and makes subjective sense, then you feel confident. It has very little to do with the quality of the information on which the story is based.

Expertise and true confidence – valid confidence – is really something quite different. Expertise is something we know — we know the conditions under which expertise develops.

Expertise has two conditions and they are quite clear: first, you cannot develop expertise unless the environment is regular and there are consistencies to be internalized. You can develop expertise in driving, for example, or in chess. You can develop expertise in poker, because, although there is a large element of chance, there are also regularities. But can you develop expertise in picking stocks? This is very doubtful. In fact, it is probably not the case, because it is such a highly irregular environment. The second condition is a vast amount of practice with immediate feedback. You have to know the consequences of the action: the feedback has to be clear, rapid and unequivocal.

In the absence of these conditions, the confidence that you experience is not “good” confidence. In general, if you want to know whether to trust somebody’s experience and expertise, you should treat it as you would treat a work of art. The most important element is not what it looks like. The most important element providence – where does it come from? Does it come from true expertise, or does it come from what many of us call judgment heuristics, which are very different processes, which also give rise to confidence, but are not based on the same thing.

 

Broad Framing

Now, the essence of rationality is what can be called broad framing. This is the essence of rationality and this is probably the primary way in which individuals, including individual investors, deviate from rationality.

A fully rational agent is supposed to have a comprehensive view. It views consequences in global terms. One of the major differences between behavioural economics and standard economics, is that, in standard economics, the individual agent is supposed to be driven or motivated by the utility of future wealth and discounted future wealth and present wealth. In behavioural economics, agents are supposed to be motivated by something else: gains and losses.

This juxtaposition of gains and losses on the one side and wealth on the other is interesting. Gains and losses are temporary — they are events. Wealth, on the other hand, is a state. It is a broader way of looking at things. In fact, what dominates our behaviour is much more immediate than considerations of wealth. It is consideration of gains and losses. That is the essential idea of both behavioural economics and behavioural finance. A fully rational agent has a broad view – it has a long horizon. But a basic finding, well replicated in psychology and decision theory, is that people are myopic and that they weigh immediate consequences much more than delayed. There is in fact brain research that indicates that there are special brain circuits that respond to relatively immediate consequences, and other brain circuits that react to more delayed consequences, and we tend to be more rationale about the more delayed consequences than about the immediate consequences.

Narrow framing, which is a characteristic of most investors’ thinking, has many manifestations. One of them – and one of the more important ones – is that people find it unnatural to take a portfolio view. Here, I am talking not about professionals, but about the clients of professionals. They tend to follow the performance of each stock separately. Many people know the price at which they bought the stock. And knowing the price at which you bought the stock is actually a bad idea; you are much better off if you do not know the price at which you bought the stock.

It turns out that when people have to sell a stock from their portfolio, they are not rational between winners and losers. People tend to sell winners and hang on to their losers. The psychology of that is quite straightforward. When you sell a stock on which you made money because you sell it for more than you bought it, then in effect, you score yourself a success. When you sell a stock for less than you bought it, you acknowledge a failure. When deciding to sell, people have control over whether to give themselves pleasure or give themselves pain, and they tend to give themselves pleasure. In other words, they tend to sell winners and hang on to losers. It turns out to be a bad idea. This is a significant difference, and a significant part of the 3.4 percent of the cost of individual ideas.

In any diversified portfolio there will be both winners and losers, and the consideration that should determine which you should sell, if any, is certainly not the price at which you bought it originally. So, a rational investor trades less, much less than real investors do, and would also trade differently: would buy different stocks and sell different stocks. Professional are closer to rationality than individual investors are.

 

Rationality & Loss Aversion

People, it turns out, are not that averse to risk. For many reasons, they are not opposed to risk, but they are opposed to losing and the possibility of loss plays a very significant part in their decision.

The major discovery that distinguishes “rational” from “standard” economics is that not only that people respond to gains and losses, but they respond differentially to gains and losses, and the main result – the main feature – is something called loss aversion: the pain of loss seems to be more intense than the pleasure of gain. And most of us have an asymmetric reaction to it.

To appreciate how loss-averse you are personally, imagine you are offered a coin toss –tails you lose 1,000 euros; heads, you win X euros. The question is, what does X have to be before the gamble becomes attractive.

The answer is actually surprising: on average, it is over 2,000 euros. That is actually much better than most investements, and yet when we have to make that naked choice about a gamble between a loss and a gain, the gain that is needed to compensate for the possibility of a loss is about twice as large, or a little more than twice as large, on the average. That has been verified in many contexts and in many different countries. Therefore, the pain of losing appears to be greater than the pleasure of winning by about 2:1, and this causes many mistakes.

People, it turns out, are not that averse to risk. For many reasons, they are not opposed to risk, but they are opposed to losing and the possibility of loss plays a very significant part in their decision.

If we take that same example and multiply it, what happens? Offer a friend a coin toss, with equal probabilities to lose 1,000 euros and win 2,000 euros and they will say they are not interested. But offer them ten such gambles – your friend may lose 10 times, and after each time, they will win 2000 or lose 1000. Of course, the friend accepts the 10 gambles – indeed, it would be completely irrational not to accept, because the probability of winning overall is overwhelming and the expected value is very large.

Now, if you accept ten gambles, should you really be allowed to reject the one? You are going to face many opportunities to make decisions; you are going to face many gambles. They’re not going to be exactly the same on the toss of a coin, with 2:1, but in effect, you will have many opportunities to make decisions very much like the present. It seems completely absurd to reject one gamble when you would accept ten of them – especially when life is very likely to offer you ten of them. What you should have – and that is what the rational individual would have – is not a preference for individual gamble. A preference for individual gambles in a prime example of narrow framing: looking at problems in isolation.

In fact, the fully rational individual would have a policy for how to decide among gambles, and the policy would be quite close to risk-neutral for gambles in a small state. So, gains and losses and narrow framing in terms of gains and losses are very costly. Individuals who manage to overcome this are going to end up richer, and more emotionally stable, because they are not thinking and they are not reacting to losses as they occur, to immediate losses — they react to that long view and they value the wealth to which they can lay claim.

There is a phrase in American business: “You win a few, you lose a few” and in a way, this phrase is the essence of practical rationality. Having that particular attitude, which is the attitude of many professional traders – they show little aversion for losses, and this is because they manage to frame consequences in this manner — produces better decisions and a much more comfortable emotional life.

 

Hindsight is 20/20

The pernicious effect of hindsight is that we get the sense, after the fact, that an event was predictable, so we get the sense that the world is predictable.

Hindsight occurs when a surprising event takes place and the surprise is very brief, replaced almost immediately by a need to make sense of it. The individual has learned something from the event. For example, if there were two football teams that you considered equally-matched, and one of them trumps the other 5-0, they are no longer equally strong in your mind. One of them is clearly better than the other. This makes sense of their victory. It also makes it virtually impossible for you to re-construct that, earlier, you thought they were equal.

Now, we think that the team that actually won “had to win”. Why did it have to win? Because it won. It won because it was stronger. How do we know it is stronger? Because it won. This is hindsight. It has a huge effect on our thinking, it has a huge effect on investing behaviour, and it has a very pernicious effect, in that it teaches us something quite wrong about the nature of reality. For example, the victory of Donald Trump was considered unthinkable, probably Donald Trump himself did not expect to win, but now that Donald Trump has won the Republican nomination, every day it makes more sense why he won. Every day it is less surprising.

Now, an example of that, of course, is the Great Recession. There are many people who predicted the Great Recession – there are many more now than there were then. The film The Big Short was based on a book, written by Michael Lewis. The book really invites you to hindsight. There are a few people – they are obviously very clever people, and they knew that the market was going to crash. And you can’t help but get the feeling that the people who didn’t know the market was going to crash were either fools or knaves. Intelligent people saw the recession coming. But in fact, and that is a well-known fact, many highly intelligent and well-informed people did not anticipate the crash. The conclusion is that the crash was not quite as predictable as it now appears. It now appears highly predictable, in hindsight.

So, the pernicious effect of hindsight is that we get the sense, after the fact, that an event was predictable, so we get the sense that the world is predictable. We think the world makes sense, and that exaggeration of the coherence, consistency and predictability of the world means that we deny the real uncertainty with which we are faced in existence. And this denial of uncertainty in turn produces irrational action.

Following his address, Mr. Kahneman sat down with Adrian Dearnell, Founder and COO of EuroBusiness Media, to discuss behavioural economics as it applies to asset managers.

   Adrian Dearnell

What tips do you have to be successful investment advisors and partners to millennials and  next-generations?

   Daniel Kahneman

I don’t know specifically about millennials, but advisors have to press people toward rationality, up to a point, by encouraging broad framing. By doing that, they will cause people to trade less, to churn less, and – one very important aspect – to check their results less frequently. Frequent checking of results causes people to want to change what they are doing and people do poorly when they change what they are doing. By and large, all professionals know that a good policy is a stable policy. The more you change it, the worse off you are. The best advice is going to be advice to resist changes.
But I will add one other thing. An advisor who preaches rationality to people is not going to be a good advisor. An advisor has to recognise that their effect on investors – therapeutic, educational, call it what you will – is limited. The investor is going to remain loss-averse. The investor is going to remain with some hindsight. The investor is going to remain prone to regret when things are going badly. Regret is a terrible guide when it comes to decision-making, but regret is a frequent guide to decision-making and the role of the advisor is going to be multiple here.

   Adrian Dearnell

Is there a utility in having an advisor, if we assume that experts do not have any particular skill in picking investments?

   Daniel Kahneman

I would think that the main utility of an advisor is therapeutic and educational, and they do have a role in that respect. But I do not believe that advisors are going to be able to give tips on the market. Very few people can do that.

   Adrian Dearnell

Does culture or age have an impact on investment behaviour? More generally, is investment behaviour homogenous, or are there clusters and if yes, what criteria shape behaviour style?

   Daniel Kahneman

There are clearly large individual differences in investment styles. Some people are much more optimistic than others. There are differences between men and women, as I mentioned, there are differences in our level of confidence and in the wish to trade, there are differences in anxiety level, there are differences in the ability to tolerate regret.

If you think about which gamble you would rather have: a gamble in which you were guaranteed a large gain, and then a small chance to win a very large gain; or another gamble, in which you are guaranteed an even larger gain, but with a small chance to lose a very large amount, people will very clearly prefer the first over the second. So we always prefer a positively skewed gamble to a negatively skewed gamble.
But if you have to live with these two gambles, for a long period of time, then for a long period of time, the people who have taken the gamble with a small probability of a big loss, every day they do better than the others. That creates regret for some people. It’s a different type of regret, and it’s a very peculiar thing that the gamble people prefer in advance, they find it harder to live with in reality. So, there are differences in there. How to detect those difference and whether there are ways indicating, that is a very subtle topic.
My guess is that most of the tests we have for people’s reaction to risk and to volatility are not very useful.