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Nobel Laureate Daniel Kahneman on the 'most costly mistake of investors'

·Reporter

When it comes to leaders, individuals are most drawn to those who exude optimism and confidence.

But some of the most desired traits of visionaries are also those that are most likely to lead to failure, according to Daniel Kahneman, co-recipient of the 2002 Nobel Memorial Prize in Economics and professor emeritus of psychology and public affairs at Princeton University.

“Optimists have something going for them … they’re more likely to persist,” Kahneman said at the World Business Forum in New York City on Wednesday. “There are many things for which optimism is very good, but it has a cost.”

And that cost, Kahneman said, is excessive risk-taking.

“When lots of people are trying to pursue opportunities against the odds, it’s not very good for most of them, most of them will fail,” Kahneman added. “But it’s very good for society and for the economy, that is to have a lot of people competing and a few of them succeeding and most of them failing. That’s the way capitalism works.”

He cited inventors as a prime example: On average, inventors’ incomes would be higher if they took jobs working for others rather than chasing their ventures, Kahneman said. Those entrepreneurs of the world that do defy the odds – think Jeff Bezos, Mark Zuckerberg and Elon Musk – are the exception, not the rule. And yet they become the ones to create the net value of society through job creation, innovation and investment returns.

“And that’s the paradox,” Kahneman said. “It’s not very good for the individual to be optimistic on average … but it gives a chance to extreme success, and extreme success is impossible without optimism and overconfidence and some exaggerated persistence.”

‘The most costly mistake of investors’

Kahneman, widely known for penning the magnum opus “Thinking Fast and Slow,” is a longtime skeptic of both optimism and overconfidence when it comes to decision-making. These qualities can lead individuals to put undue trust in their intuitions – the snap decisions that are informed by emotions and beliefs rather than by systematic evaluation.

“Having been successful is not a guarantee of future success. But it’s almost always a guarantee of future overconfidence,” Kahneman told Yahoo Finance.

Psychologist Daniel Kahneman speaks onstage during The New Yorker TechFest 2016 on October 7, 2016, in New York City. (Photo by Craig Barritt/Getty Images for The New Yorker)
Psychologist Daniel Kahneman speaks onstage during The New Yorker TechFest 2016 on October 7, 2016, in New York City. (Photo by Craig Barritt/Getty Images for The New Yorker)

The conditions under which a person can trust intuition are “very specific” and must involve practice, immediate feedback and “some regularity in the world that you can pick up and know,” Kahneman said.

“Stocks in the stock market do not have it,” he added. “The stock market is not sufficiently regular to support developing that kind of expert intuition.”

And when it comes to equity markets, investors tend to lose the most money by reacting to events, and especially to bad events, Kahneman said.

“The most costly mistake of investors undoubtedly is to churn too much,” Kahneman said. “The way I do things is I don’t look … the assumption should be that you shouldn’t change anything.”

Noise

Much of Kahneman’s writing has worked to define and evaluate the dichotomy between two categories of thought: “System 1,” an instinctive, emotion-driven fast mode of thinking, and “System 2,” or a logical, algorithmic and slower thought process.

Central to his work has been the belief that individuals place too much confidence in their judgement, without considering empirical facts of statistics and probabilities. His latest work, Kahneman told the World Business Forum audience, is on what he calls “noise,” or discrepancies in judgement among individuals that even they are not aware exist.

In a recent study, Kahneman gave a number of insurance company underwriters a case and asked them to assign a dollar value to each case and then checked to see by what percentage these values differed.

When Kahneman asked executives in the insurance company by what percentage they thought the underwriters’ values differed, the average answer was 10% – a small discrepancy. But the true answer, Kahneman said, was 50%. The results were the same when he tested claims adjusters.

“From the point of view of the company and the point of view of their customers, underwriters are interchangeable, it doesn’t matter who the underwriter is who would see your case. Well, it turns out it matters, and it matters a great deal, and there is in fact almost a lottery when people interact with employees that were supposed to be interchangeable but are not,” Kahneman said. “It affects the bottom line of businesses obviously, because if people sometimes exaggerate and sometimes underestimate, then both types of errors are costly.”

To eliminate noise, algorithms – or at the very least, slow, deliberate and calculated decisions – should be used wherever possible, Kahneman said.

“There is inconsistency in judgement not only between people but within a person, on different occasions, they will make different judgements,” he said. “That instability of judgements is large enough to make algorithms superior to people. It’s a strong finding.”

Emily McCormick is a reporter for Yahoo Finance. Follow her on Twitter: @emily_mcck

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