“If owning stocks is a long-term project for you, following their changes constantly is a very, very bad idea. It’s the worst possible thing you can do because people are so sensitive to short-term losses. If you count your money every day, you’ll be miserable.” – Daniel Kahneman
The world of business, economics and finance recently lost one of its intellectual giants – Daniel Kahneman, who passed away in March. Mr. Kahneman was a well-known psychologist, economist and author, and his contributions reshaped what we know about behavioural economics and the science of decision-making. His groundbreaking work expanded our understanding of how our minds work.
Born in Tel Aviv in 1934, Mr. Kahneman rose to prominence in part thanks to his long-time collaboration with Amos Tversky. The duo conducted behavioural experiments, which included seemingly innocent question-and-answer sessions that shone a light on our natural tendencies toward superficial and naïve thinking.
Here’s an example. An individual 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Steve is very shy and withdrawn, invariably helpful but with very little interest in people or in the world of reality.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?
Most people believe Steve is more likely to be a librarian, given the ease with which we can picture him in our minds. What we fail to realize is that, in the United States, there are roughly five times as many farmers as there are librarians and even more male farmers than male librarians. So, Steve is more likely a farmer.
Together, Kahneman and Tversky developed a framework called prospect theory, which garnered Kahneman the 2002 Nobel Prize in Economics. (Sadly, Tversky passed away before the prize was awarded.) Prospect theory challenged the prevailing academic assumption that individuals are rational and that we make choices based on what will maximize our self-interest and provide the highest benefit. Through their experiments, Kahneman and Tversky discovered a much different truth.
Instead, prospect theory suggests that people tend to be irrational when making decisions due to cognitive biases and mental shortcuts. The theory includes the concept of loss aversion. It describes how we emotionally experience loss more severely than we experience an equivalent gain. Kahneman is quoted as saying, “An investment said to have an 80% chance of success sounds far more attractive than one with a 20% chance of failure. The mind can’t easily recognize that they are the same.” According to Kahneman and Tversky, the psychological pain we feel from losses is twice as strong as the joy we get from gains. Consequently, we are biased to make choices geared to avoid pain instead of what might actually be optimal and rational.
Have you ever held a stock despite a permanent deterioration in the underlying business and reasoned that “it’s not a loss until I sell it”? Or have you “locked in a profit” only to later regret selling a great business too soon? These are good examples of the way fear of loss can cause investors to make suboptimal decisions.
On any given day, the odds of stocks being up are not much better than a coin flip, according to historical data for the S&P 500 Index. Given this fact and considering that losses make most of us feel twice as bad as gains make us feel good, it’s not a great idea to check share price performance on a daily basis. Not only will we feel the pain of loss almost half the time, but those negative feelings will also make us more susceptible to emotional mistakes.
Over longer time periods, the odds of making money on stocks increase considerably. In fact, the longer the horizon, the better the odds.
It stands to reason that investors will make fewer mistakes and achieve better returns if they monitor stock movements less frequently – and will feel better along the way, too. Of course, altering our behaviour is easier said than done. In fact, Mr. Kahneman himself noted how difficult it is to avoid our inherent blind spots. In an interview in March 2019 with Sam Harris, he was asked if he behaved any differently given what he’s learned about behavioural science. His answer was somewhat surprising:
“Not at all. In terms of my intuitions being better than they were – no. And furthermore, I have to confess, I’m also very overconfident… It’s hard to get rid of those things. I’ve been studying (this) stuff for over 50 years, and I don’t think my intuition has really significantly improved.”
Perhaps not the most encouraging words from a Nobel laureate!
That said, Kahneman’s 2011 book – Thinking, Fast and Slow – is widely considered the bible of behavioural finance. It’s not an easy read but worthwhile if you want to learn more about the science of decision-making. In it, Kahneman describes the distinction between two separate systems of thinking. System 1 is automatic and intuitive; this is “fast” thinking, the kind that just comes to you. For example, the level of thought you put into tying your shoelaces. In contrast, System 2 thinking is slow, analytical and deliberate. Solving a complex math problem calls upon a completely different system of thinking than, say, stopping at a red light. It requires a lot more mental energy.
One highly publicized study in the book looked at 10,000 different brokerage accounts to see how trading activity impacted investment performance. Researchers studied 163,000 trades over a seven-year period to compare the returns of a stock an individual sold to the returns of the stock purchased in its place, over the course of one year following the transaction. The results were not great. On average, the sold stocks did 3.2% better per year than the newly bought ones.
Our brains are naturally wired to use System 1 thinking first, which in investing might look more like a hunch than a well-formulated thesis. Shortcut thinking has its merits, but it can lead to poor outcomes when applied to complicated situations. System 1 thinking is why we suffer from loss aversion or overconfidence. It causes us to think and act in extremes, which is the basis for market booms and busts.
At our 2024 Annual Address, Executive Vice President and Director of Investment Research Murray Leith highlighted the perils of forecasting. He referenced a great quote from Mark Twain: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” He used this quote to preface a present-day example of System 1 versus System 2 thinking. Most stock market pundits assumed in 2016 that a Donald Trump presidency would be negative for the economy and the markets. As did we. This was System 1 thinking. Thanks to stimulative fiscal and monetary policies, the U.S. stock market returned 24% in President Trump’s first year in office and 70% over his four-year term.
As investors, we can aim to reduce errors by recognizing when we are applying System 1 thinking incorrectly. System 2 thinking acknowledges that sustainable investment gains are more easily made by sticking with a long-term plan and employing better habits, such as checking your investment accounts less frequently.
Thank you, Mr. Kahneman, for your wisdom and for helping us better understand ourselves.
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