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The Business Times, Weekend Edition, July 12-13, 2008

THE RAFFLES CONVERSATION 3

The father of behavioural economics Daniel Kahneman talks to


VIKRAM KHANNA

about cognitive illusions, investor irrationality and measures of well-being

ARTHUR LEE

ANY stories about the Nobel prize winning psychologist Daniel Kahneman start with a puzzle. This is one of the favourites: A bat and a ball together cost $1.10. The bat costs $1 more than the ball. How much does the ball cost? Did you say 10 cents? More than half of a Princeton University economics class gave the same answer (as did most of my friends), and it is wrong. The thought process that produced this wrong answer is an example of what Prof Kahneman calls System 1 thinking. It is, he says, fast, effortless, associative. We just impulsively pluck out the most intuitively obvious-sounding answer. We dont stop to deliberate, especially when the question seems trivial. Less frequently, we practise what he calls System 2 thinking, which he describes as conscious, deliberate, slower, serial, effortful. (The right answer to the above question is 5 cents try System 2 thinking.) System 1 works well almost all the time, he says. The problem is when it comes to big decisions. You need to know when you must slow down and recognise situations where its better to calculate rather than follow your intuition. Mr Kahneman, who won the Nobel prize for economics in 2002 and teaches at Princeton University, is widely credited together with his collaborator for some 30 years, the late Amos Tversky of Stanford as being the founder of behavioural economics. One of the insights of this relatively new discipline is that when it comes to making decisions, people are often not the selfish, rational, far-sighted, profit maximisers that mainstream economists assume them to be and which forms the basis for many policy prescriptions. There are domains in which rationality provides a good approximation of behaviour, but there are other domains in which it is not even close, explains Prof Kahneman. For example, individuals attitudes to savings at least in the US are completely irrational, and there is a need for policy intervention to enhance rationality. Many mainstream economists still view behavioural economics with a mixture of curiosity and suspicion, but they are increasingly coming around, because some of its findings are too compelling to ignore. Prof Kahneman does not however consider himself an economist. Absolutely not, he says. I study judgement and decision-making. I never really made a transition into the field of economics. What happened is that some economists became interested in our work. I learnt some economics from my friends over the years, but these were friends who were interested in what I was doing. It is evident from Prof Kahnemans deeply introspective autobiography that his interest in the workings of the human mind goes back to his childhood. At the age of seven, in German-occupied France, he was already convinced, as his mother had told him, that people were endlessly complicated and interesting. About this fundamental truth, he was to discover more and more, in a lifetime of study of the human psyche. One of his key findings was that people suffer from various cognitive illusions, which affect their decisions and their behaviour. He has documented scores of these and inspired other researchers to find even more. One of the most common problems, he

Psychologys ambassador to economics


points out, is overconfidence. It is pervasive, he says. It is very common for people to have more confidence in their judgement than they should. He gives an example: There is a great book by Philip Tetlock on political judgement. He asked people who were classified as experts people in the CIA, for example to make medium and long term judgements about political and strategic developments. And then he waited 15 years to see what actually happened. And the answer was really quite striking. Basically, he found that these experts and you know, these are people who are all over the press and so on they don't know more than the average reader of the New York Times when it comes to predicting the future. They have expertise. But their expertise is really in making judgements about the past or the present or, at best, the immediate future. They have no expertise in predicting the long term future. The same is true of financial analysts who make predictions about stocks. They have some expertise. They know how to analyse balance sheets. They understand the principles of finance. That gives them the idea that they can guess how well a stock will do. But that is nonsense they can't guess how well a stock will do. But they still feel they can, because they have expertise in some aspects of the job. So this is one of the things I am most curious about this illegitimate transfer of confidence from areas where there is genuine expertise to areas where there isnt. Prof Kahneman points out that overconfidence is also the main problem with individual investors. They trade too much, he points out. They think they know things and they dont. For me, one of the most important findInvestors often compound their erroneous buying decisions by making another common mistake in managing their portfolios. The findings show that, by a ratio of 2 to 1 or more, people sell their winners and not their losers, says Prof Kahneman. That's a mistake. It is a way to lose money, actually, and for a couple of reasons. One is that in the short term at least, winners tend to do better than losers (so its better to keep the winners). The second at least in the US is taxes. There is a great tax advantage in the US of selling losers and keeping winners. But that is not what people do, and its a major cause of losses. I ask him how well institutions invest compared with individuals. Institutions do less well than they expect, but they do better than individuals, he says. It's not that they know the future better. But they are less likely to trade on noise. A lot of trading is news-driven. And individuals are much more likely to trade on news than institutions. So institutions take advantage of this. Another common form of irrationality vis-a-vis money that individuals exhibit, is what Prof Kahneman calls loss aversion. He explains: If I offer you a deal: I toss a coin and if its heads, you will win $200, but if its tails you will lose $100. Will you take the bet? The majority of people say no. They don't consider it attractive. They weigh pleasure against pain, and for most people, the pain of losing $100 outweighs the pleasure of winning $200. Losses are given a weight of more than 2:1 compared with gains. This is loss aversion. But then, suppose you are offered not one, but ten, of the same gambles. Would you accept? Most people would now say yes, because the probability they will lose overall is smaller than in a single gamble. However, that single gamble that was first offered would not have been the last gamble of their life, so why do people turn it down? If they were rational, they would think of it as one of many gambles to come. This kind of irrationality is what he calls narrow framing. We consider decisions one at a time, we fo Prof Kahneman cus narrowly on just what we see at that moment, he explains. We also ings in behavioural finance is a finding by a consider how much we stand to gain and how former student of mine, Terry Odean, who is much we stand to lose from that one decision at the University of California at Berkeley. He in other words, we focus on changes in looked at the trading records of some 10,000 wealth, not on total wealth. investors he had access through a brokerGiven the cognitive impairments of individage. So he knew every transaction that those uals, does it make more sense to take investindividuals had engaged in. And he could ment decisions in a group setting? look, in particular, at cases where someone Not necessarily, according to Prof Kahnesold one stock and bought another stock with- man. Groups are better than individuals in in a short period of time. some situations, but not in all. That person is telling you he thinks the For example, if you have, in a group, peosecond stock will yield more profit than the ple who are all inclined to make the same misfirst stock in the future. And now you can wait take, then the group will make that mistake a year and see how well the two stocks did. and will make it with greater confidence than The result was published in the Journal of Fi- any individual, because people feel supported nance. On average, it turned out that the by the fact that others agree with them. So, stocks that people sell do better than the you need some structure to prevent errors. And what are the most common problems stocks they buy by 3.2 per cent. So if you add transaction costs, the cost of having an idea when it comes to group, and corporate, decifor an individual investor is almost 4 per cent. sion-making and what structures can be put in place to prevent them? That is enormous. Legitimising criticism and dissent is the greatest challenge, he says. The big problem is that once the organisation begins to make up its mind, everybody falls in line. And then the information that goes to the top gets biased. This is clearly something that happened with the Iraq war. What the decision makers wanted was known, and the intelligence community basically gave them the information they wanted and of course, it turned out a disaster. Preventing this from happening is difficult, he adds, but there are ways. I learnt a great idea from a friend of mine, Gary Klein. He recommends what he calls a pre-mortem. It's a very clever idea. You get the question of the ladder of life. That is, imagine a ladder with ten rungs, and the top rung is the best life possible, and the bottom rung is the worst possible life. And the question is, where are you on the ladder? There are enormous differences across countries. The world champions in happiness are the Danes. They average 8 out of 10. And people in some very poor African nations average just above 3. Singapore scored 6.2. The correlation between happiness and GDP per capita is extremely high. Across countries, the correlation is 0.84. But there is also a positive correlation between stress and GDP. He explains: stress is higher in high GDP countries than in low GDP countries. But there is more depression, anger, sadness and physical pain among the poor though not worry, which is very interesting; the poor do not worry as much as the rich. On how public policy can influence well-being, he says: If youre looking at peoples emotional state, then clearly mental illness is a very big problem. A lot of suffering in society is because of mental illness. Prof Kahneman There should be a large effort to alleviate that. a group of people who have made a plan, its Incorrect use of time is another problem. not completely final, but they have a broad People waste a lot of time. They act as if time plan. And then you bring them together for a were not a constraint, but it is a finite respecial session, 45 minutes is usually enough. source and people don't use it well. You tell them, take a sheet of paper and now Then, its very clear that people are happiimagine the following: a year has passed, we er when they are in social contact. Loneliness have implemented the plan and it is a disasis a source of misery. And simply the amount ter. Now, write down on that sheet of paper of time people spend in contact with others is what happened. Why did the plan turn out a a powerful predictor of their emotional state. To some extent there are policies that can indisaster? It's a brilliant idea. Because you have a fluence this even architectural forms matter; group of people who are now encouraged to you can shape the environment in which peothink of difficulties and problems with the ple live so that there will be more contact plan. And that solves the problem of legitimis- among them. ing dissent very elegantly, and its easy to imSo we are learning a lot about well-beplement. ing, he says. And thats enough to keep me But Prof Kahneman is not optimistic about going for the rest of my life. organisations becoming introspective. In particular, they are reluctant to go back and look at their past mistakes. It doesn't happen because its against the interests of the decision-makers, he points out. Nobody likes to expose themselves. So any systematic attempt to collect the way decisions were made which is really essential for any organisation to improve is generally sabotaged within the organisation. They just don't want to know, and they're The Raffles Conversation is brought not interested in the past. They also greatly exto you through a special aggerate the extent to which each problem is arrangement with Raffles Hotels & unique. They often think each problem is a Resorts. Ranked second among the world's top hotel brands in the 2006 new morning and so history is not relevant. Conde Nast Traveler Business To some extent, incentive structures withTravel Awards, Raffles Hotels & in companies can be changed to help resolve Resorts is a collection of luxury this problem. But only partially. When you hotels that distinguishes itself talk to CEOs, they will not want their own decithrough the highest standards of sions to be followed too closely. But you could hospitality, service and cuisine. Its get them interested in having their subordihotels in Singapore, Beijing, nates decisions improved, he points out. Cambodia, Beverly Hills, and the These days, Prof Kahneman is working on Caribbean are rated among the very what he calls well-being or on measuring best in the world. Raffles Dubai has happiness, roughly speaking. recently opened, while under One of the activities of the Gallup organidevelopment are Raffles in Tianjin, sation, which brought me to Singapore, is to Maldives, Macau, Phang Nga, conduct a world poll. I believe more than Manila, Bali and St Lucia. 250,000 people are polled across 140 countries. One of the questions they were asked is

The cost of having an idea for an individual investor is almost 4 per cent. That is enormous.

There are domains in which rationality provides a good approximation of behaviour, but there are other domains in which it is not even close.

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