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Thought Leaderby Michael Schrage
The Nobel Prize–winning economistparses the roles ofemotion, cognition,and perception in theunderstanding ofbusiness risk.
Daniel Kahneman:The ThoughtLeader Interview
P h o t o g r a p h b y M a t t h e w S e p t i m u s
bat and a ball cost $1.10 intotal. The bat costs $1more than the ball. How much does the ball cost? Almost everyone feelsthe temptation to answer“10 cents” because the sum$1.10 so neatly separates into $1and 10 cents, and 10 cents seemsthe right price for a ball (small andlight) relative to a bat (big andheavy). In fact, more than half of agroup of students at Princeton andat the University of Michigan gaveprecisely that answer — that wronganswer.The right answer is: The ballcosts a nickel.“Clearly, these respondentsoffered their responses without firstchecking,” observes Daniel Kahne-man, the Eugene Higgins Professorof Psychology and a professor of public affairs in the Woodrow Wilson School of Public and Inter-national Affairs at Princeton Uni-versity, and the winner of the 2002Nobel Memorial Prize in Econom-ics. “People are not accustomed tothinking hard and are often contentto trust a plausible judgment thatcomes quickly to mind.” You might choose to dismissthe baseball query as a trick ques-
A
s t r a t e g y + b u s i n e s s
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tion. But the pathological mistakesand the persistent miscalculationssmart people make when they
’
remaking up their minds is at thecore of Professor Kahneman
’
s path-breaking research. With his late col-laborator Amos Tversky of StanfordUniversity, Professor Kahnemancompletely reframed how econom-ics and finance define and measurerational behavior. Their provocativethinking about thinking and simple
—
yet remarkably powerful
—
ex-periments have revealed the quirks,logical inconsistencies, and flaws inhuman decision making that repre-sent the rule rather than the excep-tion in cognitive processing.Prospect Theory
—
the re-searchers
’
empirical exploration of risk assessment, loss aversion, andreference dependence
—
explains why individuals consistently behavein ways that traditional economictheory, predicated on the optimi-zation of individual self-interest, would not predict. This work di-rectlyspawned the controversial andexciting field of behavioral finance.Championed by economists such asthe University of Chicago
’
s RichardThaler and Yale
’
s Robert Shiller,author of
Irrational Exuberance
(Princeton University Press, 2000),behavioral finance defies the ration-al investor/random walk algorithmsof market analysis in favor of mod-els of judgment under uncertainty.Research undertaken decadesago by Professor Kahneman, Profes-sor Tversky, and their intellectualallies now influences hundreds of billions of dollars put into corporateinvestments worldwide. Their in-sights into the nature of human judgment have prompted funda-mental reevaluation of how individ-uals spend their time, their money,and their thought. It
’
s hard for anintellectually honest person to reada paper by Professor Kahneman without feeling a shock of recogni-tion, self-consciousness, and con-cern for the dysfunctions in his orher own thought processes. Profes-sor Kahneman
’
s work invites
—
andoccasionally demands
—
seriousintrospection by executives whoprofess to care about the quality andconsistency of their decisions. While graciously crediting col-laborators and colleagues, ProfessorKahneman has strong personal per-spectives about how the disciplinehe helped create has evolved. Thechallenge of how
—
and where
—
psychologists should draw the linesbetween intuition, cognition, and
Michael Schrage
(schrage@media.mit.edu) iscodirector of the MIT MediaLab’s e-Markets Initiative anda senior adviser to the MITSecurity Studies program.Mr. Schrage is the author of
Serious Play: How the World’sBest Companies Simulate toInnovate
(Harvard BusinessSchool Press, 2000).
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emotion is one that clearly hauntshis thoughts about thinking.Professor Kahneman talked with
strategy+business
over coffee inCambridge, Mass.
S+B:
In your classic work on incon-sistencies in individual decisionmaking, the focus seemed to be onthe fact that people make irrationalchoices even when they have prettygood information.
KAHNEMAN:
When you are inter-preting old results or old thoughts,you have to think what was in thebackground of the scientific conver-sation at the time. And at that time,in the 1970s, irrationality was really identified with emotionality. It wasalso obvious that a lot of explicit rea-soning goes on: It was absolutely clear to us that people can computetheir way out of some things. But we were interested in what comes tomind spontaneously. That led to thetwo-system theory.
S+B:
Can you describe the two-system theory?
KAHNEMAN:
Many of us whostudy the subject think that thereare two thinking systems, whichactually have two very differentcharacteristics. You can call them
intuition and reasoning, althoughsome of us label them System 1 andSystem 2. There are some thoughtsthat come to mind on their own;most thinking is really like that,most of the time. That
’
s System 1.It
’
s not like we
’
re on automatic pilot,but we respond to the world in waysthat we
’
re not conscious of, that wedon
’
t control. The operations of System 1 are fast, effortless, associa-tive, and often emotionally charged;they
’
re also governed by habit, sothey
’
re difficult either to modify orto control.There is another system, System2, which is the reasoning system. It
’
sconscious, it
’
s deliberate; it
’
s slower,serial, effortful, and deliberately controlled, but it can follow rules.The difference in effort provides themost useful indicator of whether agiven mental process should beassigned to System 1 or System 2.
S+B:
How did you begin yourresearch into the two systems?
KAHNEMAN:
In our first paper,Tversky and I did a study of the sta-tistical thinking of professional stat-isticians when they
’
re thinkinginformally.We found what wecalled the Law of Small Numbers, aterm we coined in 1971 to describehow people exaggerate the degree to which the probability distributionin a small group will closely resem-ble the probability distribution inthe overall population. And we alsofound that people, experienced stat-isticians, do not apply rules thatthey
’
re aware of in guessing theprobability of statistical outcomes.
S+B:
So even “good” statisticianscan be “bad” statisticians.
KAHNEMAN:
That
’
s right. Whenthey
’
re not computing seriously inSystem 2 mode, they rely on theirintuitions for the kind of simpleproblems we gave them. We werehoping that, where things really mattered, they would replace theirintuitions with computations. Yet what was striking to us was thateven people who should know bet-ter were making those mistakes.
What’s Risky
S+B:
Has your perception of risk andthe meaning of risk evolved orchanged since you began doing thiswork?
KAHNEMAN:
The perception of and reaction to risk previously hadbeen seen as emotional.
S+B:
Not just seen as emotional;
dismissed
as emotional.
KAHNEMAN:
Yes, exactly right.Our innovation was that we identi-fied some categories of risk that were the result of certain cognitiveillusions. That was a novelty andthat got people excited. But it
’
s only part of the picture. There is an alter-native way of looking at this that isbecoming much more fashionable.There
’
s a paper that I really like alot. The title of it says the wholestory:
“
Risk as Feeling.
”
The idea isthat the first thing that happens toyou is you
’
re afraid, and from yourfear you feel risk. So the view of risk is becoming less cognitive.
S+B:
So it’s not that generalizedemotion influences decision making.It’s that one emotion — fear — dis-torts the perception of risk and intro-duceserror into decision making.
KAHNEMAN:
What actually hap-pens with fear is that probability doesn
’
t matter very much. That is,once I have raised the possibility that something terrible can happento your child, even though the possi-bilityis remote, you may find it very difficult to think of anything else.
S+B:
It’s like a Lorenzian imprintingof goslings: The phenomenon of fearimprints on a decision maker.
KAHNEMAN:
Emotion becomesdominant. And emotion is domi-nated primarily by the possibility, by what
might
happen, and not somuch by the probability. The moreemotional the event is, the less sen-sible people are. So there is a big gap.
S+B:
You’re saying that the shadowcast by a worst case overwhelmsprobabilistic assessment?
KAHNEMAN:
We say that peoplehave overweighted the low probabil-ity. But the prospect of the worstcase has so much more emotional
oomph
behind it.
S+B:
So even experts make cogni-tive mistakes. But experts and exec-utives in organizations don’t makedecisions in isolation. They makedecisions in meetings and commit-tees and groups. Do we have thecounterpart of System 1 and System2 thinking in groups as well as indi-viduals?
KAHNEMAN:
We know a lot aboutthe conditions under which groups
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