Daniel Kahneman, an Israeli-born American Nobel prize-winning author, passed away on March 27 at age 90. For those yet to become familiar with his work, he was a psychologist at heart but to many he will be remembered as a pioneer in what has become known as behavioural economics. His extremely impressive resume includes a tenure with Princeton University, winner of the Nobel Prize in economics (in 2002), and more well-known in the investing circle, author of Thinking Fast and Slow–an international best-seller providing great insights into the human mind. (Ir)rational BehaviourMuch of the teaching in economics (even to this day) assumes that people will behave rationally. That is, using all the information at their disposal, they will make unbiased decisions that are in their own best interests. This includes concepts such as “inferior goods”: when a consumer’s income increases, they will purchase less of a particular item (cabbage is an oft-quoted example in university lectures). They will also purchase more of a particular item when the price of the good goes down, or less of a particular item when the price increases. Yet through the work of Kahneman, and others such as his lifelong accomplice Amos Tversky and now Jason Zweig of the Wall Street Journal, we know that many of these assumptions regarding rationality are at best limited, and at worst, utterly false. Look no further than what are known as “Giffen goods”: think luxury items such as handbags or automobiles. For these items, the high price actually creates part of the allure and prestige. The reality is that the more expensive Giffen goods are, the more people want to purchase them. It is interesting to note that many successful investors and business owners profit from the realities that fly directly in the face of these rational theories. Companies like Ferrari (BIT: RACE) know that the higher price of their cars will (counter-intuitively) create greater demand for them, and See’s Candies (NYSE: BRK.B) knows that people generally will not purchase less of their chocolate if the price is higher, because it is highly valued by consumers and usually purchased on special occasions (most often as a gift). We have seen through Richard Branson’s experiments with cola that even a comparable taste and a comparable price wouldn’t get consumers to switch away from Coca-Cola (NYSE: KO), and we intuitively know that a lot of people will pay more for junk food rather than food that is healthy. Economists: Helpful After the FactThere is an incredible range of insights to be gleaned from Kahneman’s work–far too much for a single article. However, one key realisation was the inherent challenges of using economic forecasts to generate outsized investing returns. We have previously highlighted the scepticism of other great investors regarding economic predictions, including chairman and CEO of Berkshire Hathaway Warren Buffett: “forecasts may tell you a great deal about the forecaster; they tell you nothing about the future” and distressed bond giant Howard Marks: “I’ve listened to a lot of economic briefings, and I’ve had a lot of visits from economists, and I’ve never encountered one who was right consistently.” Kahneman was equally sceptical, pointing out the uncertainty in economics on more than one occasion. A couple of his more poignant quotes were:
Understanding OneselfMuch of Kahneman’s work evolved from studying his own mistakes to understanding the judgment and decision-making processes behind them. In particular, he analysed people’s willingness to rush to judgement by using mental shortcuts (“heuristics” he named them), which they typically stuck with and rarely re-examined even with evidence to the contrary. These heuristics included the tendency for people to overestimate trends based on small sample sizes, believing things that they are more familiar with regardless of the facts, generalising the larger group based on the characteristics of a small number of members, comparing new situations with previous situations, and even when people do change their views, the new belief is still usually related to their prior beliefs. Kahneman’s work was consistent with the belief/statement/findings from the author of Security Analysis and The Intelligent Investor (and the so-called father of value investing) Benjamin Graham: “the investor’s chief problem–and even his worst enemy–is likely to be himself.” We have previously highlighted the Morningstar annual “Mind the Gap” study that estimates the return of the average dollar invested in funds and ETFs (the “Investor Return”) compared to the average fund’s total return. In the decade ending December 31, 2022, Morningstar showed that the average investor returned 6% annually versus an average fund return of 7.7% annually. That is, investors in the same funds returned 1.7% per year less than the return of the fund. Peter Lynch, the wildly successful fund manager at Fidelity Investments who delivered a compounded return of more than 29% per year between 1977 and 1990, also lamented the fact that few (if any) of the investors in his Magellan Fund achieved the staggering returns on offer. Instead of ignoring these human weaknesses, Kahneman focused intently on them, using his introspection and self-doubt to fuel his study. In fact, he believed that “confidence is not a very good indicator of accuracy, an idea certainly backed by Howard Marks: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” A True Pioneer into the Investing MindDaniel Kahneman spent more than 50 years exploring the human mind, and made some truly revolutionary findings that essentially led to the creation of a new field, behavioural economics. He clearly articulated the ways in which humans stray from the previously-held belief of rational behaviour and went a long way to explaining concepts such as loss aversion (the tendency for investors to suffer the pain of losses more keenly than the pleasure of equivalent gains), cognitive dissonance (the inability to mesh two ideas together), and a range of heuristics that impact rational thought. Thinking, Fast and SlowWhile many Nobel laureates might take a step back after their achievements, Daniel Kahneman continued to forge new paths in understanding human cognition. In his 2011 groundbreaking work "Thinking, Fast and Slow," Kahneman delves into the dual processes that govern our thinking: fast thinking, which is instinctual and automatic, and slow thinking, which is deliberate and analytical. Slow thinking is deliberate, rational, and self-aware, but only comprises 2% of our thought process. Kahneman's work highlights the dangers of relying on fast thinking for complex decisions that require logical reasoning. His book has become a cornerstone in fields such as psychology, investing, business, and public policy. At TAMIM, we closely align with Kahneman's concept of slow thinking, as it mirrors our commitment to second-level thinking. We continually challenge ourselves to ensure our decisions are not just quick reactions but are grounded in rationality and deeper analysis. Kahneman's insights serve as a constant reminder to approach decision-making with a balance of intuition and thoughtful deliberation, a principle that is integral to our investment philosophy. Vale Daniel KahnemanKahneman’s findings are critical for anyone who has ever asked themselves why they sold a winning stock too soon, how to sell losers more quickly, how to think about luck versus skill, or simply control their natural impulses better. In fact, they are not just critical for becoming a world-class investor but valuable for working in many different fields or applications, or simply for anyone who wants to understand the human world better.
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