In the early 1970s, Amos Tversky and Daniel Kahneman, two Israeli psychologists, started working together on the subject of people’s attitudes to risky choices. The standard theory in psychology at the time, indeed in all social sciences including economics, was the ‘expected utility theory’. In 1979, they published their results in a paper titled “Prospect Theory: An analysis of Decisions under Risk.”
Kahneman says: “Our theory was closely modeled on utility theory but departed from it in fundamental ways. Most important, our model was purely descriptive, and its goal was to document and explain systematic violations of the axioms of rationality in choices between gambles.” (Kahneman, 2011)p.271.
This was the beginning of the study and application of behavioral psychology to decision making. Ultimately Kahneman, following the death of Tversky, became a recipient of the Nobel Prize in Economic Sciences. Tversky would undoubtedly have shared the prize had he been alive. Today their ideas have become an important adjunct to economics and finance.
A large recent international study replicated the essential results of Kahneman and Tversky’s Decision Theory work. Replication is the key scientific method used to verify psychological study results.
Ideas about ‘violations of rationality’, ‘decision making’ and ‘risky choices’ are naturally of great interest to investors.
Daniel Kahneman tells us that in those early days, the field of decision theory “had a theory, expected utility theory, which was the foundation of the rational-agent model and is to this day the most important theory in the social sciences. Expected utility theory was not intended as a psychological model; it was a logic of choice, based on elementary rules (axioms) of rationality.” He continues: “Economists adopted the expected utility theory in a dual role: as a logic that prescribes how decisions should be made, and as a description of how Econs make choices.” (Kahneman, 2011)p.269-270.
Kahneman explains: “To a psychologist, it is self-evident that people are neither fully rational nor completely selfish, and that their tastes are anything but stable. Our two disciplines [psychology and economics] seemed to be studying different species, which the behavioral economist Richard Thaler later dubbed Econs and Humans.” Thaler’s Econ is the same as homo economicus, the latinized intelligent self-interested economic actor. To my way of thinking Econ’s psychological make-up is more Greek than Roman. He is the Platonic form of the perfectly rational man. Thaler recently received a Nobel prize. When I use the italicized Human or Humans I am referring to the word Humans as used by Thaler and Kahneman. For them, a Human was simply a normal human being who is neither fully rational nor completely selfish. Similarly, Econ is their homo economicus.
We have already been introduced to Mr. Market. He is described by Warren Buffet as having incurable emotional problems. In truth, his emotional problems are the least part of it. What he really suffers from is behavioral biases and a propensity to make cognitive errors. Mr. Market is not an Econ, to use Richard Thaler’s term. He is a Human.
So what are behavioral biases and cognitive errors? Psychologists, particularly behavioral psychologists study, amongst other things, both the behavioral side and the cognitive side of Humans. The cognitive side is the mathematical, logical and rational side. Cognitive errors are errors in how we think through problems or solve problems. Investors, like all Humans, regularly make cognitive errors that contribute to poor performance. We will also see that investors, like all Humans, regularly exhibit behavioral biases that also contribute to poor performance. Behavioral biases are systematic errors in our impressions and feelings that result in quirks of behavior that one would not expect of normal rational people.
Psychologists use these terms behavioral biases and cognitive errors. For the most part the line between the two is clear. Sometimes it is unclear as to whether a fault or error is the result of biases in behavior or an error in cognitive function.
Most discussion of behavioral biases and cognitive errors and investing discuss lists of biases and errors and the impact they have on investors. Experts have identified scores of biases and errors. I have come at it somewhat differently. I have identified eight ways in which behavioral biases and cognitive errors harm our investing. In the eight Chapters that follow the present one, I go through each of these eight topics and explain the various biases and errors that are at work. I then explain how investors can overcome the problems.
Before we did into these topics there are some key ideas from behavioral psychology we should take a look at and some terms will need to be defined.
This Chapter continues with these Sections: