This past week, the influential psychologist and economist Daniel Kahneman passed away at age 90. The winner of the 2002 Nobel Prize in Economic Sciences, Kahneman wrote the bestselling book Thinking, Fast and Slow where he explained the two systems of thinking that shape human decisions. These include “System 1,” which relies on fast, automatic and unconscious thinking, and then “System 2,” which requires attention and concentration and works more slowly. And it’s the interplay of these two systems that profoundly shapes the quality of our decisions in different parts of our lives, including investing.
In the interview above, Steve Forbes asks why individual investors persist in believing that they can pick stocks successfully over time, despite ample evidence to the contrary. Drawing on his research, Kahneman describes the “illusion of skill,” where investors “get the immediate feeling that [they] understand something,” which is much “more compelling than the knowledge of statistics that tells you that you don’t know anything.” Here, System 1 creates the “illusion of skill,” and it overwhelms the slower analytical thinking found in System 2—the System that could use data to determine that stock picking is a fool’s errand. When Forbes asks if investors should ultimately opt for index funds instead of individual stocks, Kahneman replies “I am a believer in index funds,” that is, unless you have very rare information that allows you to pick stocks successfully.
Later in the interview, Kahneman touches on another important subject. In his mind, the first question every investor should ask is not how much money should I plan to make, but rather, “How much can I afford to lose.” Every investor should assess their risk tolerance, in part so that you can handle turbulence in the market and stick with your initial investment plan. If you are not aware of your risk tolerance, “when things go bad, you will want to change what you are doing, and that’s the disaster in investing… Loss aversion can kill you.” He continues, “Emotions are indeed your enemy. The worst thing that could happen to you … is to make a decision and not stick with it, so that you bail out when things go badly, so that you sell low and buy high. That is not a recipe for doing well in the stock market, or anywhere.” Ideally, you should figure out upfront how much you want to put in the stock market, and how much you want to keep out, so that you can psychologically manage the ups and downs of investing.
From here, Kahneman comes to his most important piece of advice for investors: Know yourself in terms of what you could regret. If you are prone to regret, if investing makes you feel insecure and lose sleep at night, then you should adopt a “regret minimization strategy” and create a more conservative portfolio to match it. Read more about that here. Also see Chapters 31 (Risk Policies) and 32 (Keep Score) in Thinking, Fast and Slow where Kahneman talks more about investing.
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