Early economists developed their theories assuming that humans are perfectly rational. They assumed that people would make careful calculations, consider all the facts, and only then take economic and investment decisions. These theories were updated when it was shown that humans are often irrational and often make emotional decisions that may not be in their own best interests. The question then arose as to whether human behavior is randomly irrational, i.e., whether human behavior was so emotional that one could not say which way a person or group would react to a given situation.
It was Daniel Kahneman, who with his longtime friend Amos Tversky, first began a series of experiments to show that while humans were not rational, their irrational behavior can be correctly predicted.
Kahneman and Tversky showed that most of us suffer from innumeracy. This is the inability to reason correctly with numbers and probabilities. We make quick decisions, and often even when we try and take time to consider, say, an investment opportunity, we do not have the experience or expertise to correctly evaluate the mathematics behind the problem.
In his book, Thinking, Fast and Slow, Kahneman gives the following problem. Can you solve it? (Dear Reader, When I first read the problem – I got it wrong!)
- The taxis in a city are 85% green in color and 15% blue in color.
- A person sees an accident involving a taxi. The person says it was a blue taxi.
- The person correctly identifies the color blue 80% of the time, and 20% of the time identifies the color as blue when it was actually green.
- What is the probability that the color of the actual taxi that had the accident is blue?
The answer is given at the end of this essay, but the point is that this is not such an artificial problem as it might seem. In many significant decisions; in investing, bargaining, deciding who to marry! Humans are unable to make a proper evaluation of the odds of success.
Two other major biases that Kahneman points out are:
Confirmation bias: We all read and accept information that aligns with our preconceived beliefs. Even when the data and evidence show something different, we mostly believe only what we want to.
Overconfidence bias: In a famous experiment, people in a group are asked to rank their ability to solve a problem as being in the top 50% or bottom 50%. Over 90% of the people rank themselves in the top 50%. By definition, this cannot be so! Only half the people would rank in the top 50%. This shows that we all suffer from overconfidence in our abilities.
Kahneman got a Nobel Prize in 2002 for developing Prospect Theory. This theory explains how humans react to losses and gains. This is especially important to understand for anyone who is an investor.
Before Kahneman’s experiments and theory, economic and investment theory was based on the assumption that people correctly calculate the chances of future gains and losses. Kahneman’s findings are that people chose the less optimal choice if they believe they can minimize losses. That is, people are biased in terms of trying to avoid the pain of losses.
Kahneman has also done a lot of research on human happiness. Kahneman says that “We live and experience many moments, but most of them are not preserved. They are lost forever. Our memory collects certain parts of what happened to us and processes them into a story. We make most of our decisions based on the story told by our memory.”
Kahneman thus points out that there is a difference between what we actually experience in a particular moment and what we later remember about the experience. This leads Kahneman to say that what drives him is to have life-satisfaction, which is “connected to achieving goals and meeting expectations.”
The Importance of Kahneman
The key learning from Kahneman’s research is that we are all better off if we pause, try, and think carefully about problems and decisions, keeping kindness, happiness, and long-term satisfaction in mind.
Kahneman has spent a long life with many deep friendships. Professor Richard Layard, a British economist, said that perhaps the most important contribution of Kahneman is that “He made happiness respectable as a goal for society.”
(The answer to the problem is a probability of 0.41)
© Kaikhushru Taraporevala