Daniel Kahneman's view of investing: How do humans make money-related choices?

"The investor’s chief problem – and even his worst enemy – is likely to be himself." - Daniel Kahneman

Investing is a domain where rational decision-making is paramount, yet human behavior often deviates from rationality. How can we make better and more rational decisions in investing? One of the ways is to understand behavioral economics. You need to know Daniel Kahneman and his investing view. In this article, we look at the details of Daniel Kahneman and understand how humans make money-related choices.

Introduction to Daniel Kahneman

Kahneman, along with Amos Tversky, is considered a founding father of behavioral economics. What is this field about? It challenges the traditional economic assumption of perfect rationality and instead, explores how psychology influences our decision-making.

Kahneman's research led to the development of prospect theory, which explains how people make decisions under uncertainty. He also identified and documented numerous heuristics and biases (covered later) that influence our judgments and choices. In recognition of his groundbreaking work, Kahneman was awarded the Nobel Memorial Prize in Economic Sciences in 2002, along with Vernon L. Smith.

Human investment theory before Daniel Kahnemman's theory

Before Daniel Kahneman's Prospect Theory revolutionized the field, human investment theory relied heavily on the idea of rational actors. It meant that traditional economic models assumed investors were:

Perfectly logical: They would gather all available information, analyze it objectively, and make investment decisions based on maximizing expected utility (return) while minimizing risk.
Emotionless: They would not be swayed by emotions like fear or greed when making investment choices.
Always seeking optimal outcomes: They would make perfectly timed trades and consistently choose the best possible option.

Some prominent pre-Kahneman theories

Modern Portfolio Theory (MPT): It is a framework developed by Harry Markowitz that aims to maximize portfolio returns while minimizing risk by diversifying investments. The theory suggests that investors can optimize their portfolios by combining assets with different levels of risk and return, taking into account their correlations. MPT emphasizes the importance of achieving an efficient frontier, where the highest return is attained for a given level of risk or the lowest risk is maintained for a given level of return.

Capital Asset Pricing Model (CAPM): It is a financial model that establishes the relationship between risk and expected return for assets. It suggests that the expected return on an asset is determined by its systematic risk, measured by beta, relative to the market as a whole. According to CAPM, the expected return on an asset equals the risk-free rate plus a risk premium, which is proportional to the asset's beta multiplied by the market risk premium. CAPM is widely used in finance to estimate the required return rate for investments and to evaluate the performance of investment portfolios.

Works of Daniel Kahneman

Daniel Kahneman has written books and given a lot of theories. His groundbreaking work in behavioral economics had a significant impact on our understanding of financial decision-making. His work is relevant to the world of investing because of Prospect Theory.

It is one of Kahneman's most influential contributions. His groundbreaking work in behavioral economics has had a significant impact on our understanding of financial decision-making.

It challenges the traditional economic assumption that people make decisions based solely on maximizing expected gains. Instead, prospect theory suggests that our decisions are also shaped by how we perceive losses. Investors tend to be more sensitive to losses than gains. It means that it can lead to irrational behavior in the investment world. For example, investors might be more likely to hold onto a losing stock in the hope that it will rebound, even if the evidence suggests otherwise.

Biases Daniel Kahneman talked about

Here are some of the biases Daniel has talked about:

Confirmation Bias: The tendency to seek out information that confirms one's existing beliefs or hypotheses while ignoring or downplaying contradictory evidence.
Availability Heuristic: Have you ever made investment decisions based on readily available information or examples that come to you when making judgments or decisions rather than considering all relevant information. If so, it is the availability heuristic.
Anchoring Effect: You read that stock X will give 100% returns, and the info stuck with you. The tendency to rely too heavily on the first piece of information encountered (the anchor) when making decisions, even if that information is irrelevant or misleading.
Overconfidence Bias: The tendency to overestimate one's own abilities, knowledge, or judgment, leading to excessive risk-taking or unwarranted certainty in decision-making.
Loss Aversion: The tendency to strongly prefer avoiding losses over acquiring gains of the same magnitude, leading to risk-averse behavior and reluctance to take actions that may result in losses.
Sunk Cost Fallacy: The tendency to continue investing resources (time, money, etc.) into a project or decision based on past investments, even when those investments are unlikely to be recovered or are no longer relevant to the decision at hand.

Investing Lessons by Daniel Kahneman

Here are some of the investing lessons by Daniel Kahneman:

Acknowledge Your Biases: We all have biases that influence our thinking and decision-making. Kahneman's research highlights these biases, such as overconfidence, anchoring, loss aversion, and herding. Recognizing how these biases might affect your investment choices is crucial.

Beware of Emotional Investing: Fear and greed are powerful emotions that can cloud your judgment. Prospect theory suggests we feel losses more intensely than gains. It can lead to panic selling during downturns or holding onto losing stocks for too long. Develop strategies to stay calm and rational during market fluctuations.

Focus on the Long Term: Market fluctuations are inevitable. Don't get caught up in the short-term noise. Instead, focus on your long-term investment goals and develop a plan to achieve them.

Before you go

Daniel Kahneman's pioneering research has illuminated the psychological mechanisms driving investment decisions. By understanding the biases, heuristics, and cognitive traps outlined in prospect theory and behavioral finance, you can become a better investor.