Kahneman and your head
The Nobel Prize-winning economist claims not to understand economics, but he has sage advice for the irrational investor.
I have to admit that since earliest childhood, I've loved gambling. Some claim gambling isn't a rational matter: the gambler is largely using intuition, even if he has absolute faith in his model. I feel the gratification from the act of gambling - frequenting a casino - overcomes the tumult in the mind. The outside world, with its shattering complexity, recedes; your only concern is to win. That concentration of purpose is worth the loss.
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Some years back I switched to a slightly less risky game, ostensibly more based on logic: stocks. Yet behold! My results were even worse than at the blackjack tables. Relying on "expert" advice, articles and corporate ratings, two months ago I bought stock in the Bank of America. It dropped like a stone. A technology company I'd liked became embroiled in a control battle. Even casino stocks lost money. So I leaped at the opportunity to meet Prof. Daniel Kahneman, 2002 Nobel laureate in economics who debunked the assumption that the operative agent in economic matters is the rationale.
The agent may want to believe that he's being rational, said Kahneman and his partner Amos Tversky (since deceased ): but it can't be. Take a look at the world outside.
It makes sense, doesn't it?
Less obvious are the circumstances of our meeting.
In the 1950s, as a pre-army university student, Kahneman studied the army's model for evaluating draftee potential. He found the existing tests failed to predict how soldiers would behave and what they would achieve during service. He proposed substantial changes to the model, which are used to this day. Fifty-plus years later, he's back at Tel Hashomer, accompanied by his biographer, to hear how the model has changed since.
Soldiers mill in the courtyard outside the building, wearing trendy sunglasses, with polished toenails, chatting in English. The army has changed since my discharge. The biographer, Michael Lewis, fretted at the size of the entourage. He might have been even jumpier had he known that his name almost triggered a mini-riot at the base: Hearing about the visit, the young soldiers had jumped to the not-irrational conclusion that "Michael Lewis" was the Israeli actor of the same name. Yet they surely were not disappointed by this man.
Colonel Aviva Shaked, commander of the IDF Behavioral Sciences Center, elaborated on the changes the IDF has made in evaluation methods. She debunked myths about the importance of socio-economic status, and the marital status of parents in determining a soldier's "grade". Then they talked about the potential of future soldiers. On the screen appeared terms such as possibilities, qualities, choice. I remembered that the first offer the army made me was driving lessons. I told Prof. Kahneman that I had questions about economic matters. "I don't understand economics, even though I have a Nobel Prize in it," he answered. Clearly I needed a different strategy.
Are companies irrational?
"Even so, I'm interested in the difference you wrote about in the past, between the goals of a company or bank (stability, long-term planning ) and the goals of the agents running them, who want immediate profit, immediate gratification and personal success. Does that mean that all the companies we know are by nature irrational bodies?"
"That's Alan Greenspan's mistake," Kahneman answered. "He saw companies as rational beings that made decisions in that spirit, but didn't understand that the agents running them are not necessarily rational, but had other, immediate goals. You see, the risks the banks took were really not rational for the banks. But because of the incentive method in the U.S., these risks were perfectly rational for the agents. After all, they wouldn't personally cover the gigantic losses caused by their decisions."
We progressed to an amusing simulation. Kahneman was tested like a draftee. He answered the questions at length, courteously, told of his mother, and father who had died in France in 1944. (The family had fled the Nazis, several times; the father did not survive to see their defeat. ) He spoke of his love for literature, chess, swimming at the YMCA pool. He told of his deliberation at age 14 about being religious or not (and concluded that God took no interest in him, so he wouldn't take an interest in God ). At the end of the test, he was not told his grade. That isn't done any more, he was told, to avoid alienation between the testee and tester.
Why bankers don't act for the general good
The testers told Kahneman and Lewis of offbeat cases: For instance the arsonist who burnt down his house and almost set fire to his granny's too, but did his service. "The Jewish people are always prepared to defend the motherland," nodded the spokesman's representative. He may not have been speaking ironically. This generation is more patriotic than ours, for sure. Also, the articulateness of testers and testees alike was impressive.
"Professor," I took the opportunity as we climbed stairs, "you dwelled on the tendency to cling to things as they are, to see that as the point of origin that sets expectations. Maybe that's why, even after the crisis, there has been no broad debate on changing the capitalist system in general? Maybe we cling to it just because it exists?"
"It's hard to give a clear answer," he said. "Obviously there is tension between granting economic freedom to get the best from people, and supervising their actions. I believe overly tight control is damaging. But on the other hand, financial organizations, partly because of their incentive methods, do not necessarily act for the greater good of the economy. They take risks that can damage the entire economy, and themselves. That demands attention."
Can the average person invest rationally? He will always lack a great deal of information, won't he? Perhaps we'll always be driven by intuition?
"A person behaving intuitively in the market is behaving foolishly," Kahneman says unequivocally.
We discussed his finding that people would choose to earn a guaranteed NIS 900 over a 90% probability of earning NIS 1,000. But if asked whether they'd lose NIS 900 or accept a 90% probability of losing NIS 1,000, they chose the second option. To Kahneman, the two results demonstrate irrationality. Why does it happen? Because people respond more strongly to loss than to gain of the same exact magnitude.
I asked how that tendency could be neutralized.
"The best way to overcome fear of losses is to link a lot of decisions together. That's what people do in business," he says. "They don't look at the financial results of each decision alone, but put together the outcome of multiple decisions. The investor should also be aware of the expression: 'You win some, you lose some.'" Adopting that maxim can largely overcome the irrational effect, he says.
"Is the fact that most people accept the rule of rich families with their tentacles throughout the economy, rational?" I asked. "It obviously contradicts most people's interests."