A New York Times bestseller held in high esteem, it explores much of the research conducted by its author and his colleagues into cognitive biases and heuristics.
Daniel is an Emeritus Professor of Psychology at Princeton University and in 2002 was awarded the Nobel Memorial Prize in Economic Sciences for his work with Vernon Smith in Prospect Theory. This made him an ideal candidate to glean knowledge from.
Having studied psychology for the entirety of his academic career it never occurred to Kahneman that he would have such an influence on the field of economics, particularly as he states he has never so much as taken a course in the subject. Kahneman was taught everything he knows about economics thanks to a chance meeting with Richard Thaler, both of which are credited as being some of the fathers of behavioural economics. This may be a somewhat generous title given that Adam Smith’s Theory of Moral Sentiments came out in the 1700’s but it is undeniable that they have certainly brought behavioural economics to the forefront of economic discussion and this book and its associated works have gone a long way to achieving that.
The central theory of the book revolves around the concept of two cognitive systems working to various extents to form decisions.
System 1: The fast element of our brains, this primarily utilises heuristics in order to make instinctive and automatic decisions on the limited information available.
System 2: The slow portion of our brains, which requires active thought and uses calculation and deliberation in order to come to conclusions.
Both systems are immediately recognisable and have their own strengths and weaknesses. System 1 may initially be good at reading body language but would struggle with complex mathematics. Conversely, system 2 would be used to help solve a riddle but would have a hard time calculating the necessary force at which to kick a football. Both systems must be used at different stages in order to avoid making errors however, due to the additional energy needed to engage system 2 we can often become victims of our own rash thought processes. Kahneman’s book identifies various situations in which mistakes are likely with the intention of allowing the reader to avoid such errors, particularly where the consequences are high.
We tested one of these scenarios ourselves known as the anchoring effect. This is the tendency for an individual to place disproportionate emphasis on a number they have been exposed to recently in relation to a value they are evaluating. The most common example of this being at sales where you see the RRP of an item before the sale price, you may feel you are saving a considerable amount of money on the item despite the RRP having no real impact on the intrinsic value that item has to you. Despite this, even seemingly random numbers can influence our decision-making process, as demonstrated by our book club. We were asked to write the day of the month our birthday fell on and a bid for a bottle of wine. Although these numbers were seemingly unrelated, those with birthdays that fell in the latter half of the month bid on average c.40% higher for the wine than the rest of the group. This result was remarkable however, we may have fallen victim to another one of Kahneman’s heuristics, the law of small numbers, in finding significance amongst such a small dataset.
Overall the book was deeply fascinating. A lot of the individuals within the group felt that they had read various iterations of this book and the studies contained within it but I feel this is testament to the proliferation of the concepts identified and the success of the book. Although primarily focused on psychology and behavioural economics the book is still very much applicable to the world of investment where decisions often bear high consequences. It has certainly helped in identifying areas where we are predisposed to making logical errors and allow us to alter our approach.
This is a must read for all individuals as the subject matter is relatable to many facets of everyday life and written in a highly accessible manner. My words hardly do justice to the works of Mr Kahneman and I would certainly recommend grabbing a copy for yourself.
This book was reviewed by By Atticus Kidd, Wealth Planning Assistant.
The JM Finn book club, consisting of a dozen or so investment professionals across the firm, was conceived in 2017 with the hope being that, month by month, some of the wisdom of investing gurus such as Warren Buffet, Charlie Munger, and Mohnish Pabrai, might rub off on their eager selves.