Imagine your office as a factory, a factory that produces decisions. Leadership decisions. Investment decisions. People decisions. All of them human decisions. According to Nobel Economics Prize winner Daniel Kahneman, these decisions are flawed, biassed and inaccurate. “If people made better decisions, the world would be a better place.”
As a Princeton University psychologist, Daniel Kahneman won the 2002 Nobel Prize for Economic Sciences for his groundbreaking work that applied psychological insights to economic theory. He taught the world that human judgement and decision-making under uncertainty are prone to inaccuracies. His theory holds valuable lessons also for investors.
Professor Kahneman, 88 years old, was invited to share his wisdom on decision-making by retail investors at the 2022 Amundi World Investment Forum in Paris. On the fringes of the event, he shared his views on recent international developments in an interview with Investment Officer.
‘Huge disappointment’
“The world has become so much worse in the last six, seven years,” said Kahneman, who survived World War 2 as a Jewish boy in Paris. “Things that we would consider impossible have happened. You know, everybody can think of the same three you know, President Trump, Brexit and Ukraine. All of these things appeared extraordinarily unlikely before. And now that they have happened, the world has really changed, I think it’s a huge disappointment.”
Kahneman said he does not believe that the world would be a better place if everyone had read his books, but he does recognize a clear need for a better quality in decision-making. “There is a lot of room for improvement in decision making, both public and private. So, if people made better decisions, the world would be a better place,” he said.
“Some decisions like the war in Ukraine are so obviously mistakes that, yes, you wonder. They raise the issue of the quality of decision making, and of the quality of the institutions that support decision making. And, and especially, one gets worried about dictatorships, especially prolonged dictatorships that get to the point where people do not get good information anymore, and therefore, they do not make good decisions anymore. So that’s, yeah, there’s a lot to worry about.”
Inflation exploited ‘by unscrupulous politicians’
Asked about inflation and its possible impact on dynamics in society, Kahneman noted that people who have lived through periods of economic downturns when they were young are more fearful than those who have not. “Young people are not afraid enough of it,” he said.
“What we do know is that people have lived through inflation or through recessions in their formative years, that marks them forever in the same way that people’s taste in music, apparently is determined in the younger years and doesn’t change. So there is a kind of fear that, you know, people who’ve lived through that have.”
The inflation dynamic, he said, can easily be exploited by politicians.
“The rise of populism is clearly a factor, and, and it’s unexpected. And in some ways, it reminds one of what happened in Italy and Germany, in the 20s, and early 30s. The dynamic lends itself to exploitation by unscrupulous politicians. And so yes, I think there is a lot of reason to worry,” said Kahneman, who survived World War 2 as a Jewish child in Paris.
Flaws in human judgement
Kahneman’s latest book, published in May last year, is titled “Noise; a Flaw in Human Judgement,” co-authored with Olivier Sibony and Cass Sunstein. After he first identified bias as an error in decision-making, he now looked at “noise” as another source of mistakes. His theory around noise also holds value for those making decisions in financial services, such as insurance companies keen to accurately determine risk premiums.
“Noise is a different kind of error, but it’s an extremely important kind of error. We think of noise as measurement in judgement, as measurement noise. Judgement is really like measurement, like the instrument in the human mind. But basically, it’s the same,” he said.
“In the theory of measurement, when you’re measuring a long line with a very, very fine ruler, and you do it repeatedly, you’re not going to get the same result every time, you’re going to get variability. That variability is noise,” Kahneman explained.
“Bias is the average error, whether you exaggerate or underestimate the length. Noise is simply the variability. And it’s obvious that even if you have zero bias, noise is a source of inaccuracy, because you’re not hitting the bull’s eye, but you’re all over the place. It turns out that when you do the mathematics, that noise and bias are mathematically equivalent in their importance. People are not aware of the amount of noise.”
Five times more disagreement
Kahneman applied his noise theory as a consultant to an insurance company. Several dozen underwriters were asked to put a premium on a single case. The management, he said, believed there would be a margin of error of about 10 percent. With his ‘noise theory’, Kahneman made clear to the management that the margin of error was actually significantly bigger.
“The true answer was 50 percent. So there is five times as much disagreement as people expect,” he said, adding that noise, “clearly is about randomness in decision-making”.
Asked about his lesson for investment firms, Kahneman said that the variability in analyst estimates leads to sub-optimal performance, which is something firms need to be aware of, especially those that have many analysts.
“Noise, as we describe it, is interesting actually to firms that have many analysts. Analysts, it turns out, are highly variable in their estimates. The variability of analysts is bound to create sub optimal performance. So that’s a problem for the firm. What we were doing in the book is to call attention to the fact that noise is actually a big problem for organisations.”