On 27 March 2024, Daniel Kahneman, the renowned cognitive psychologist, famous for his work on decision-making, sadly passed away.
His research greatly improved our understanding of how the brain works when making choices, and some of the thought patterns and biases that could lead to poor decision-making. Kahneman applied these theories to the financial world and in 2002, was awarded the Nobel Prize in Economics.
Daniel Kahneman’s theories are as relevant today as they were when he first developed them, and they could inform your investment strategy. Most importantly, the teachings might stop you from making mistakes that could affect your returns or increase your exposure to risk.
Read on to learn three crucial investing lessons from the late Daniel Kahneman.
1. Activate the logical part of your brain when making investment decisions
Economists championed Daniel Kahneman for his many insights into human behaviour and how it affects financial decision-making. Yet, it was his theory about “System 1” and “System 2” thinking that was perhaps most influential.
Previously, psychologists believed that we were essentially rational beings, gathering and weighing up all available information before making decisions. Kahneman argued that isn’t the case.
Instead, he suggested that we have two ways of thinking – System 1 and System 2.
System 1 is the automatic part of our brain that makes fast, unconscious decisions. These decisions are often based on emotion and snap judgments, and Kahneman believed that System 1 makes 98% of our choices.
This is a good thing in one sense because it keeps us alive. When we’re in danger, we don’t have time to carefully weigh our options; we need to make a decision and take action. Additionally, we make thousands of small choices each day and System 1 filters through these automatically, preventing cognitive overload.
System 2 makes the rest of our decisions. This cognitive process makes more calculated decisions, gathering information and making assessments. It’s far more logical and less prone to emotion. You might engage this type of thinking when completing a task that requires lots of attention, such as parking a car or solving a crossword.
Unfortunately, System 1 is often our default, and this can affect investment decisions. For example, during periods of market volatility, System 1 might take over and tell you that you’re losing money, and that you should sell your investments now before it gets worse.
These choices could be damaging to your financial plan because you haven’t taken the time to look at the situation logically and consider all outcomes. Most importantly, you’re not taking a long-term view of your investments.
You may find that you make more measured decisions if you let System 2 take over in these situations. The best way to do this is to slow down and give yourself time to think clearly.
Instead of panicking about short-term fluctuations in the value of your investments, consider the long-term growth and refocus on your financial goals. You may want to seek advice from your financial adviser too as they can act as an impartial sounding board.
Once you activate System 2 thinking, you take emotion out of the equation and make decisions based on information. Often, you might find that short-term fluctuations are less likely to affect your ability to achieve your long-term goals, so you don’t need to change your investment strategy.
Even if you do need to adapt to changing circumstances, you can think carefully about all your options instead of making a snap decision. Ultimately, this could mean that you’re more likely to make choices that encourage long-term growth.
2. Don’t let fear of losses prevent you from making gains
Daniel Kahneman, along with his colleague Amos Tversky, was the first to develop “prospect theory” – the idea that people typically opt for certain gains with a lower level of risk rather than increasing their risk to potentially secure larger gains.
In investing terms, this means people may be likely to choose a less risky investment with lower annual returns instead of high-growth investments that may carry more risk.
Prospect theory was underpinned by the observation of a specific cognitive bias – an illogical pattern of thinking influenced by past experiences – called “loss aversion”.
Loss aversion suggests that people feel the pain of a loss more acutely than the pleasure of a gain. In simple terms, losing a £10 note would elicit a stronger reaction than finding £10 on the floor.
So, when considering an investment, you might focus on the risk and the potential for loss, without considering the growth you could see in the future. Unfortunately, this may mean that you shy away from calculated risks and, as a result, limit your ability to grow your wealth and achieve your financial goals.
If you want to potentially maximise your investment returns, you may need to overcome your fear of loss and adopt a level of risk that is suitable for you and your financial goals.
That said, it’s important to perform due diligence and take steps to balance your risk, such as diversifying your portfolio. Working with a financial adviser can help you achieve this.
3. Gather all available information when researching investments
Cognitive biases are the bedrock for many of Kahneman’s theories on decision-making and “confirmation bias” is another important one for investors to be aware of.
This bias explains how people often come to a conclusion and then find evidence to support it, discounting anything that doesn’t confirm their existing beliefs.
You might fall victim to this way of thinking when researching investments. For example, you may decide that you want to invest in a certain fund, so you check its past performance.
Imagine that the fund only saw positive growth in three out of the past 10 years and decreased in value the rest of the time. Somebody falling victim to confirmation bias might focus on those three positive years as evidence that they’re likely to see growth in the future.
Yet, if you can overcome your confirmation bias and review all available information, you’d consider the seven years of negative returns too. As a result, you may decide that the fund exposes you to more risk than you’d like.
This is a simple example, but it demonstrates the importance of avoiding confirmation bias when researching investments. Working with a professional can be incredibly valuable here because they can be objective about investments and perform due diligence without bias.
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Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term (minimum of 5 years) and should fit in with your overall risk profile and financial circumstances.
