R.I.P. Daniel Kahneman

R.I.P. Daniel Kahneman

Daniel Kahneman (Danny to his friends) passed away last month at the age of 90. He was a psychologist and researcher who applied psychology to economic analysis with his close friend and collaborator Amos Tversky. The resultant field of behavioral economics has grown over the years to become an integral part of good financial planning.

Kahneman was best known publicly for his groundbreaking 2011 book “Thinking Fast and Slow,” in which he identified two discrete modes of human thinking: one rational and deliberative (slow), and the other emotional and instinctive (fast). He demonstrated through numerous studies how our decision-making is frequently sub-optimal as a result of inherent emotional human biases.

He was born in Israel and graduated with a psychology degree from Hebrew University in Jerusalem.  After being drafted into the Israeli Defense Forces Kahneman was given the job of assessing how well the military identified candidates for officer training. He discovered just how badly their performance predictions turned out to be. In the process he identified a cognitive bias (overconfidence in one’s expertise) that permeated the army’s approach to the problem.

As a financial planner, time and time again I run across many of the biases that Kahneman & Tversky have written about. One of the most common is loss aversion (they called it Prospect Theory). Simply put, we are more willing to avoid the pain of a loss than to choose the pleasure of an equivalent gain. When a new client joins our firm one of the first things we do is evaluate their investment portfolio. Frequently we discover funds or securities that are likely to underperform their particular asset class (e.g. because of cost) or that are weighted inappropriately in the portfolio based on the client’s financial goals. If the position is currently sitting at a loss, many clients resist selling it because they don’t want to incur the loss. “I’d rather wait until the price comes back to what I paid for it,” they’d typically say. Behavioral economics suggests that the decision can be reframed to: “Well, would you buy more of that fund today?” If the answer is “no,” it can be more easily explained how the decision to keep the security is identical to the decision to buy it today. Thanks to Kahneman’s research we are able to help many clients overcome their cognitive biases and make more rational financial decisions.

Kahneman won the Nobel Prize in 2002 for his work, and would undoubtedly have shared it with Tversky had the latter not died in 1996. His lifelong quest, according to Robert Hershey in the New York Times, was to understand how the human mind works. I’m pleased to see that Danny Kahneman is getting the recognition he so richly deserves.

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