Behavioral economist and 2002 Nobel laureate, Daniel Kahneman has transformed the fields of economics and investing. At their most basic, his revelations demonstrate that human beings and the decisions they make are much more complicated — and much more fascinating — than previously thought.
At a conference in Hong Kong, Kahneman delivered a captivating mini-seminar on the key ideas that drove his scholarship, exploring intuition, expertise, bias, noise, and how optimism and overconfidence influence the capitalist system. And, he shared, how we can improve our decision making.
Today we’re going to look at what I consider are some of the strikingly poignant points he made at the conference.
Hopefully, you all know who Kahneman is.
I think one of the more relevant blogs I ever wrote on the psychology of trading was based on his book, “Thinking – Fast and Slow.” The blog was titled, “Two Brains Walk into a Bar.”
Optimism
“Optimism is the engine of capitalism,” Kahneman said, “But over-optimism is a curse. It’s a curse and a blessing. The people who make great things, if you look back, they were overconfident and optimistic — overconfident optimists. They take big risks because they underestimate how big the risks are. “But by focusing on only the success stories, we trick ourselves into learning the wrong lesson.”\
“If you look at everyone,” he said, “there is lots of failures.” Doesn’t that remind you of survivorship bias?
The Perils of Intuition
Intuition is a form of what Kahneman calls fast thinking, or System 1, one of the two brains who walked into a bar. It is the kind of thinking on which we often base our decisions. This is the brain that gets us into trouble. The one that says, “Ya jump off that bridge with a flimsy bungee cord wrapped around your ankle. It’ll be fine.” “Ya jump off that bridge with a flimsy bungee cord wrapped around your ankle. It’ll be fine.”
The problem is, “We trust our intuitions even when they’re wrong,” he said. How many times have you trusted your intuition and were able to tell yourself that one more Dairy Queen Peanut Buster Parfait won’t make any difference on the scale? Speaking from experience here.
Intuition
Interestingly though, we can trust our intuitions — but those intuitive inclinations have to be anchored in reality. And while we develop expertise through experience, sadly experience alone isn’t enough.
Research clearly shows that experience fortifies our beliefs. Stubbing your toe on the dining room chair fortifies your belief you need to wear shoes around the house.
However, that same research shows that the depths of our beliefs have nothing to do with accuracy or reality. We can be 100% certain of a belief that is 100% wrong. In the 1400’s people were 100% certain the world was flat. Turns out that belief was 100% inaccurate. We can be 100% certain of a belief that is 100% wrong
Expertise requires a particular kind of experience, one that exists in a context of reality but also predictable enough so the rules can be learned.
“Is the world from which we build and then fortify our intuition regular enough so that we have an opportunity to learn its rules?” Kahneman asked.
When it comes to the finance sector, the answer is no.
“It’s very difficult to imagine from the psychological analysis of what expertise is that you can develop true expertise in, say, predicting the stock market,” he said. “You cannot because the world isn’t sufficiently regular for people to learn rules.”
I want you to read that again!
“It’s very difficult to imagine from the psychological analysis of what expertise is that you can develop true expertise in, say, predicting the stock market,” he said. “You cannot because the world isn’t sufficiently regular for people to learn rules.”
In other words, (or in my words), the stock market is too unpredictable to give the kind of feedback needed to build a reliable intuition.
Yet that doesn’t stop people from confidently predicting financial outcomes based on their experience. How many times have you heard statements like, “The SPY is building an outside day candle so tomorrow we’ll see a huge market rally?”
“This is psychologically a puzzle,” Kahneman said. “How could one learn when there’s nothing to learn?” He went on to say, “That sort of intuition is really only superstition.” Yikes! “That sort of intuition is really only superstition.
“When somebody tells you that they have a strong hunch about a financial event,” he said, “the safe thing to do is not to believe them.” The safe thing to do is put your fingers in your ears and yell, “LA LA LA LA.” You know like your two-year-toddler does when he doesn’t want to listen to you.
Next week we’ll look at noise, biases, hindsight and Kahneman’s four simple strategies for better decision making that can be applied to both finance and life.
We’re the Plan in “Plan your Trade and Trade your Plan” – TraderJanie
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