Nobel Prize winner Daniel Kahneman published Thinking, Fast and Slow in 2011, and it shot to the top of bestseller lists. The reviewers often sounded as if Kahneman were reporting on new research or putting out a fresh idea, like a Michael Lewis or Malcolm Gladwell insight. But this did an injustice to Kahneman. His book was nothing less than a summary of a lifetime’s work. His Nobel Prize was awarded in 2002, and he traces his work back to 1969 at the Hebrew University of Jerusalem, when he met Amos Tversky. Together, they would bring behavioural finance out of the margin and into the mainstream, such that over 40 years later, it is an accepted part of understanding how investors and markets behave.
But this article is not another review of his book. Rather, Kahneman reports on dozens of studies he and his colleagues have done on how we make decisions, and explains our irrational behaviour. The reader is drawn in to take the tests and judge their own weaknesses in logic, which is why this book can be so humbling to read.
Kahneman divides our thought processes into System 1, which is automatic, effortless and unconscious, but answers questions quickly and gullibly based on intuition. And System 2, which is controlled, deliberate and requiring effort, but often only engages when circumstances require it.
Try these quick questions
So here we go. I’ve taken 10 examples from Kahneman’s book, and I will give the questions first, followed by the answers and a brief explanation. Try not to peep.
- A bat and a ball cost $1.10. The bat costs one dollar more than the ball. How much does the ball cost?
- If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets? Here’s a clue: is the answer 100 minutes or 5 minutes?
- How many animals of each kind did Moses take into the ark?
- A man has been described by a neighbour as follows: “Steve is very shy and withdrawn, invariably helpful but with very little interest in people or in the world of reality. A meek and tidy soul, he has a need for order and structure, and a passion for detail.” Is Steve more likely to be a librarian or a farmer?
- Consider three possible sequences of boys and girls born in a hospital: BBBGGG, GGGGGG, BGBBGB. Which of these sequences is least likely?
- Is the height of the tallest redwood in the United State more or less than 1,200 feet? What’s your best guess about the height of the tallest redwood?
- It’s a fact that people with a PhD are more likely to subscribe to The New York Timesthan people who did not go to college. You see a lady reading The New York Times on a New York subway. Which of the following is more likely? a) She has a PhD or b) She does not have a college degree.
- The most famous and controversial experiment involves a lady called Linda. “Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in antinuclear demonstrations.”The question is, which alternative is more probable? a) Linda is a bank teller b) Linda is a bank teller and is active in the feminist movement.
- What if you were given a choice between the following:a) A gamble with 80% chance to win $100 and 20% chance to win $10, or b) A sure payment of $80. Which would you choose based on your personal preferences? Which would you choose based on the expected value of the outcomes?
- Consider these two problems:
Problem 1. Which do you choose? Get $900 for sure or 90% chance to get $1,000.
Problem 2. Which do you choose? Lose $900 for sure or 90% chance to lose $1,000.
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What are the logical or rational answers and what is happening in your decision-making?
- It’s difficult to stop the answer 10 cents jumping into your mind. More than 80% of university students give this first intuitive answer. But it’s wrong, and Kahneman highlights our failure to check the answer as we simply follow the law of least effort. The correct answer is 5 cents.
- Again, there is an intuitive response, but the correct response is 5 minutes. Kahneman also reports that students are far more inclined to make a mistake if given the puzzle in normal font, but do better in a small, washed-out font. The cognitive effort of reading the question produces a better result.
- Very few people detect what is wrong with this question. Look again. Holy Moses! Oh Noah!
- Most people reply that Steve is more likely to be a librarian than a farmer. But there are at least five times more farmers than librarians in the United States, and the majority of the librarians are women. So it is far less likely that Steve is a librarian.
- Intuitively, we don’t expect a sequence of six girls, but since each event is independent of the one before it, they are all equally likely.
- When the question is asked like this, the mean estimate given by respondents was 844 feet. But when it is asked like this: “Is the height of the tallest redwood more or less than 180 feet? What’s your best guess about the height of the tallest redwood?” … the mean answer is 282 feet. This ‘anchoring’ effect has many examples in investing.
- It’s more likely to be the second because far more non graduates ride the subway than PhDs.
- People think Linda is a very good fit for an active feminist. But the set of feminist bank tellers must be wholly included in the set of bank tellers. Therefore, the probability that Linda is a feminist bank teller must be lower than the probability she is a bank teller. When a possible event is specified in increasingly greater detail, you only lower its probability. People are confusing intuition with the logic of probability. In tests of undergraduates at top universities, 85% to 90% chose the second, incorrect option.
- Most people dislike risk and almost everyone prefers the sure thing. The expected value of the gamble is $82 (0.8 X 100 + 0.2 X 10), which is more than the sure thing. But few people evaluate risks in this way. Most people would choose the sure thing even if it were only $50.
- You were probably risk-averse in problem 1, as for the great majority of people, a $900 gain is much better than a gamble. But then in problem 2, you probably chose the gamble. The thought of losing $900 encourages you to take the bet. People become risk-seeking when all their options are bad, and you probably dislike losing more than you like winning.
Kahneman hopes his examples improve our ability to identify and understand errors of judgement. If we make mistakes in these simple questions where the logic is obvious, we are likely to be missing critical information or focussing on the wrong issues in many of our investment decisions. Each day, we respond to problems quickly and automatically, giving undue attention to details that stand out easily. Critical information is often ignored. The best investors are those who can hear through the noise.