Kahneman's book Thinking: Fast and Slow is well worth reading and digesting. I've discussed it in presentations and books.
This article by his editor is a wonderful summary.
Excerpts:
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Before the pioneering work done by Kahneman and his research partner, Amos Tversky, who died in 1996, economists had assumed that people were “rational,” meaning we are self-interested, use all available information to make unbiased decisions, and our preferences are consistent.
Kahneman and Tversky showed that’s nonsense. Their findings, directly or indirectly, inspired change across the business world, including the redesign of organ-donation programs and improvements in planning for multibillion-dollar infrastructure projects.
Kahneman was a pioneer of what became known as behavioral economics, although he always saw himself as a psychologist. Investors who take Kahneman and Tversky’s lessons to heart can minimize fees, losses and regrets. Kahneman may well have had more influence on investing than anyone else who wasn’t a professional investor.
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For years, as an investing journalist, I had wondered: Why are smart people so stupid about money?
About five minutes into Danny’s presentation, I realized he had the answers—not only to that question, but to nearly every mystery of financial behavior.
Why do we sell our winners too soon and hang onto our losers too long? Why don’t we realize that most hot streaks are just luck? Why do we say we have a high tolerance for risk and then suffer the torments of the damned when the market falls? Why do we ignore the odds when we know they’re stacked against us?
Danny paced softly back and forth at the front of the room, his blue-green eyes sparkling with amusement as he documented these behaviors and demolished conventional economic theory.
For decades, he and Tversky had conducted experiments, almost childlike in their simplicity, to see how people really think and behave.
No, Danny said, money lost isn’t the same as money gained. Losses feel at least twice as painful as gains feel pleasant. He asked the conference attendees: If you’d lose $100 on a coin toss if it came up tails, how much would you have to win on heads before you’d take the bet? Most of us said $200 or more.
No, people don’t incorporate all available information.
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Ask people if they want to take a risk with an 80% chance of success, and most say yes. Ask instead if they’d incur the same risk with a 20% chance of failure, and many say no.
Noting that the stocks people sell outperform the ones they buy, Danny joked that “the cost of having an idea is 4%.
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“The most important question to ask before making a decision,” he told me, “is ‘What is the base rate?’”
He meant you should begin every major decision by figuring out the objective odds of success, given the historical range of outcomes in similar situations.
If you’re thinking of starting a new business, your gut might tell you there’s no way you can fail. According to the Bureau of Labor Statistics, however, half of new businesses die within the first five years. That base rate comes from millions of startups, each of which also expected to succeed. You, on the other hand, are a sample of one.
Knowing that the base rate is 50/50 shouldn’t deter you from trying, but it should prevent you from being unrealistically optimistic.
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In the beginning, I wrote the first drafts of chapters that never saw the light of day. Gradually, Danny took over the writing, agonizing over every sentence, as I rewrote and edited.
Late in 2007, as we were polishing the chapter called “The Illusion of Validity,” I woke up one night in an icy sweat, pulse racing, gasping for air. My wife rushed me to the emergency room. It turned out I hadn’t had a heart attack; I’d had a panic attack, the only one in my life before or since.
Danny was even more alarmed than I was.
In 2008 I moved on, joining The Wall Street Journal. Neither of us would ever publicly discuss our book divorce; Danny finished the final third of the book without me.
“Collaborations don’t always end well,” he’d warned me on our first day of work together, “so I want to make sure you will always think of me as a mensch,” a good person.
And so I do—the most complicated mensch I’ve ever known.
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Working on the book exposed me to three of Danny’s qualities I hadn’t previously encountered in their full intensity. Only years later did I realize that I’ve internalized them as a journalist and an investor. Or so I hope.
First, Danny saw everything through a child’s eyes or, as some people call it, “beginner’s mind.” No one else I’ve ever known has so often asked: Why? Instead of assuming the status quo is valid, Danny always started by wondering whether it made any sense.
He was also relentlessly self-critical. I once showed him a letter I’d gotten from a reader telling me—correctly but rudely—that I was wrong about something. “Do you have any idea how lucky you are to have thousands of people who can tell you you’re wrong?” Danny said.
Finally, Danny could rework what we had already done as if it had never existed. Most people hate changing their mind; he liked nothing better, when the evidence justified it. “I have no sunk costs,” he would say.
One of his favorite words, while working on the book, was “miserable.” He used it to describe whatever we had just written; the process of writing a book; and, above all, himself.
Danny’s misery was largely rooted in the decades he and Amos had spent exploring the failings of the human mind by picking apart their own errors of thought and judgment.
Taking the outside view on everything else had given Danny the outside view on himself. He embodied the ultimate form of self-knowledge: to distrust yourself above all.
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Born in 1934 in what today is Tel Aviv, Israel, while his mother was visiting there, Danny was raised in France. He spent much of his childhood hiding from the Nazis in barns and chicken coops in the French countryside.
He insisted that didn’t explain much about him; after all, not every survivor of the Holocaust had become a self-critical psychologist fascinated by financial behavior.
Instead, he credited his success to hard work—but even more to luck, especially meeting Tversky.
Danny also insisted that studying the pitfalls and paradoxes of the human mind didn’t make him any better at problem-solving than anybody else: “I’m just better at recognizing my mistakes after I make them.”
For all his knowledge of how foolish investors can be, Danny didn’t try to outsmart the market. “I don’t try to be clever at all,” he told me. Most of his money was in index funds. “The idea that I could see what no one else can is an illusion,” he said.
“All of us would be better investors,” he often said, “if we just made fewer decisions.”
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