Almost anyone who has ever heard the word ‘behavioural finance or economics’ might have heard about or read about ‘Daniel Kahneman’, the famous Nobel prize winner for his stupendous work in the space of uncovering cognitive biases of humans among financial decision making.
Born in 1934 in what was then British Mandatory Palestine, Kahneman’s early years were marked by uncertainty and adversity. Amidst the chaos of World War II, Kahneman observed how people’s decisions were often driven by emotion rather than logic. Whether it was the panic of fleeing refugees or the desperation of those facing scarcity, he saw firsthand how fear and uncertainty could cloud judgment and lead to irrational choices. These formative experiences planted the seeds for Kahneman’s lifelong exploration of the human psyche and its implications for decision-making.
Tragically, Kahneman’s recent passing in March 2024 has left a hole in the field, but his legacy lives on in the continued application of his insights to financial decision-making. Today, investors around the world continue to draw inspiration from Kahneman’s journey, recognizing the enduring impact of his contributions to understanding the human mind in finance. Let’s explore some of Kahneman’s teachings here as well, one more time in his remembrance, and learn the art of investing:
1.Holding On Or Letting Go: Imagine you’re considering selling a stock that has been underperforming. Despite mounting evidence suggesting it’s time to let go, you hesitate, fearing the regret of selling too soon if it rebounds. As per Kahneman’s work, this reluctance to accept losses, known as loss aversion, can lead to holding onto losing investments longer than necessary. Kahneman’s insight reminds us to base investment decisions on objective analysis rather than emotional attachment.2.Safe bets Vs High Risks:
Picture yourself evaluating two investment opportunities: one with a guaranteed return and another with higher potential but greater uncertainty. Most investors would choose the safer option, even if it means sacrificing potential gains. Kahneman’s prospect theory reveals our tendency to avoid losses and seek certainty, often at the expense of maximizing returns. By balancing risk and reward, investors can construct portfolios aligned with their risk tolerance and financial goals.
3.From Cocky to Cautious:
Think of a novice investor who confidently enters the market, convinced they’ve uncovered a surefire investment opportunity. Ignoring warning signs i.e. our limitations and expert advice, they dive in headfirst, only to suffer significant losses. Kahneman’s research underscores the dangers of overconfidence, reminding investors to approach decisions with humility and seek diverse perspectives.
4.Locked In the Past:
Consider a scenario where an investor fixates on a stock’s historical performance, assuming it will continue to follow the same trajectory. Despite changing market conditions and new information, they cling to outdated beliefs, potentially missing opportunities or exposing themselves to undue risk. Kahneman’s concept of anchoring warns against relying too heavily on past data or predetermined reference points. By regularly reassessing investments based on current information, investors can adapt to evolving market dynamics and make more informed decisions.
5.Following the Flock:
Imagine observing a market downturn and witnessing a mass exodus of panicked investors— selling off their assets. While the rational response may be to stay the course or even consider buying undervalued assets, emotions often drive individuals to follow the crowd. Kahneman’s insights from behavioural economics highlight the role of fear, greed, and herd mentality, emphasising to have long-term perspective, investors can capitalize on opportunities created by market irrationality and avoid succumbing to short-term impulses.
This is not all, but as you reflect more and more on the fascinating world of behavioural finance and the insights shared by Daniel Kahneman, remember this: investing isn’t just about numbers on a screen—it’s about understanding the human side of the equation.
And, overcoming behavioural biases is no small feat, So, whether you’re a seasoned investor or just starting out, embrace the quirks of our minds, learn from our biases, and let them guide you towards smarter decisions.
Kahneman also emphasizes the challenge of slowing down a bit and consciously engage our deliberative minds to combat these behavioural biases, however, the underlying mechanisms driving these biases are deeply ingrained and not easily changed. This is where I believe, a financial advisor can play a crucial role. By providing objective insights and expertise, advisors can help investors recognize and mitigate the presence and impact of behavioural biases. They can offer a steady hand during times of market volatility, guiding investors to make rational, informed decisions rather than succumbing to emotional impulses, ultimately steering them towards long-term success and achieving their financial goals.
Happy Investing The Kahneman’s Way!
Sagneet Kaur, SVP, Behavioural Finance & Consumer Insights, PGIM India Mutual Fund
