THE MASTERS SERIES

The Human Side of Decision Making

Thinking Things Through with Daniel Kahneman, PhD

D
aniel Kahneman is widely considered the tant of these were “Judgment under Uncertainty:
most influential psychologist in the world Heuristics and Biases,” published in 1974 in
today. He is best known in the financial Science, which introduced the idea of judgment
realm for pioneering work that helped to lay heuristics, including anchoring; and “Prospect
the foundation for behavioral economics, which Theory: An Analysis of Decision under Risk,”
studies the psychology of judgment and economic published in 1979 in Econometrica. In 1977, Dr.
decision making and its impact on the financial Kahneman and Dr. Tversky met Richard Thaler,
markets. Together with his long-time collabora- who later became the leading figure in behavioral
tor Amos Tversky, Dr. Kahneman explored the Daniel Kahneman, PhD economics. Dr. Kahneman has called his friend-
ways in which human judgment systematically ship with Dr. Thaler “the second most important
departs from the basic principles of decision theory when professional friendship” of his life. Dr. Kahneman and Dr.
evaluating economic risk, consequently creating the concept Tversky subsequently became involved in the development of
of prospect theory. Their findings challenged fundamental this new approach to economic theory, eventually collaborat-
economic assumptions and expanded the boundaries of ing on several papers with Dr. Thaler.
research by introducing psychologically realistic models into In 1978, Dr. Kahneman moved to Vancouver to take
economic theory. So ground-breaking are their discoveries a position as professor of psychology at the University of
that New York Times columnist David Brooks has called Drs. British Columbia. He continued to collaborate with Dr.
Kahneman and Tversky “the Lewis and Clark of the mind.” In Tversky, who had accepted a position at Stanford University
2002, Dr. Kahneman’s work was recognized with the Nobel the same year, and the two completed their study of framing
Memorial Prize in Economic Sciences for his integration of over the next several years. Dr. Kahneman also collaborated
insights from psychological research into economic science. with Dr. Thaler on a variety of topics that integrated psychol-
Born in Tel Aviv in 1934, Dr. Kahneman spent his ogy and economics, including the endowment effect and
childhood—including the period of the Nazi occupation public views about fairness in economic transactions. From
(1940–1944)—in France before moving to British Palestine 1986 to 1993, Dr. Kahneman returned to the University of
(now Israel) in 1948. In 1954, he earned a bachelor of science California, Berkeley, as professor of psychology. During the
degree with a major in psychology and a minor in mathemat- 1990s, Dr. Kahneman’s research focus shifted to hedonic
ics from The Hebrew University of Jerusalem, then joined psychology—the study of what makes experiences and life
the Israel Defense Forces, where he served in the psychology pleasant or unpleasant, satisfying or unsatisfying—as well as
branch. His responsibilities included evaluating candidates to studies of well-being that built on his previous research
for officer training school and developing a method for about experienced utility. Recently he has been working to
interviewing combat unit recruits, which much later provided develop and promote adversarial collaboration within the
some of the basic ideas of his work with Amos Tversky on social sciences. During the course of his academic career, Dr.
judgment. According to Dr. Kahneman, “This was the begin- Kahneman also has been associated with the University of
ning of a lifelong interest in the statistics of prediction and Michigan, Harvard University, the Russell Sage Foundation,
description.” In 1958, he began PhD studies at the University the Canadian Institute for Advanced Research, and the
of California, Berkeley. After completing a doctorate in Applied Psychological Research Unit in Cambridge, England.
psychology in 1961, Dr. Kahneman returned to The Hebrew Since 1993, Dr. Kahneman has been associated with
University of Jerusalem as a lecturer in psychology; he was Princeton University, where he is the Eugene Higgins
promoted to senior lecturer in 1966 and later to professor. Professor of Psychology, Emeritus, and Professor of
In 1969, Dr. Kahneman began his long collaboration with Psychology and Public Affairs, Emeritus; he is also a Senior
Dr. Tversky, a fellow psychology professor at The Hebrew Scholar at Princeton’s Woodrow Wilson School of Public and
University. Their first jointly authored paper, “Belief in the International Affairs and a Fellow at the Center for Rationality
Law of Small Numbers,” was published in 1971. Over the at The Hebrew University of Jerusalem. Since 2004, he has
next thirteen years, Dr. Kahneman and Dr. Tversky worked served as a Gallup senior scientist, advising and consulting
together to produce a series of seminal articles in the field with Gallup researchers on behavioral economics and his
of judgment and decision making. Among the most impor- recent research on psychological well-being. Dr. Kahneman

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is a founding partner of The Greatest Good, a business and impact on investors’ well-being. Taking part in the discus-
philanthropy consulting company formed with the goal of sion were Margaret M. Towle, PhD, the Journal editor-in-
applying cutting-edge data analysis and economic methods to chief, of HighTower Advisors; Mark Anson, PhD, of Oak
the most salient problems in business. He is a consultant to Hill Investments; Edward Baker of The Cambridge Strategy;
Guggenheim Partners, an investment advisory firm. Geoffrey Gerber, PhD, of TWIN Capital Management; and
Dr. Kahneman has written and edited numerous books Meir Statman, PhD, of Santa Clara University. This interview
and authored more than 170 articles for professional journals. is the twelfth in the Journal’s Masters Series, which presents
The 1974 Science paper and the 1979 Econometrica paper topical discussions with leading experts and visionaries in
that he co-authored with Dr. Tversky are among the most fre- finance, economics, and investments.
quently quoted works in social science; Dr. Kahneman him- Margaret Towle: First of all, Dr. Kahneman, thank you
self was cited in scholarly journals more than 28,000 times so much for agreeing to spend some time with us today.
between 1979 and 2011, according to the Thomson Reuters We’re all well-acquainted with your exceptional background
Web of Science data base. The Decision Analysis Society pre- and contributions, and we hope to get a little more insight
sented Dr. Kahneman with its Publication Award for the best into the factors that helped to shape your career. Looking
paper published in 2003 for “Maps of Bounded Rationality: back over your experiences—from your childhood in Nazi-
Psychology for Behavioral Economics.” Dr. Kahneman’s recent occupied France, your collaboration with Richard Thaler1 in
book, Thinking, Fast and Slow (2011), summarizes much of behavioral economics, through your recent work in intuition
his research, is a bestseller, was selected as one of the best and the role that it plays in scientific investigation—what do
books of 2011 by the New York Times Book Review, the Wall you regard as the major factors that shaped your career and
Street Journal, the Economist, and Canada’s Globe and Mail; brought you to where you are today? Your accomplishments
and won the Los Angeles Times Book Prize. are too numerous to list, of course, but what do you consider
your major achievements?

“
Daniel Kahneman: I think there’s no question about the
A s you know, m ost of my main determinant of my career, and that was the joint work
with Amos Tversky.2 As you know, most of my research has
res ea rc h has been col l a borative. been collaborative. So having brilliant friends, I think, is the
secret of any success I have achieved. In addition, there is
So having br illiant fr iends, I think, a large element of being in the right place at the right time
is t he s ecret of any success I h ave intellectually, that is, answering questions to which people

”
are interested in hearing your answers. So, yes, I’ve been very
a c h i eve d. fortunate. Clearly, if you want to understand what I’ve done,
it’s mostly collaborative.
Margaret Towle: What about on the other side, that is,
Dr. Kahneman has received every major award in the what you would consider—I don’t know if we want to call
field of psychology, including the American Psychological them mistakes—but your biggest disappointments in terms of
Association’s 2007 award for outstanding lifetime contribu- events that happened throughout your career?
tions to psychology and the University of Louisville’s 2003 Daniel Kahneman: The worst thing that happened in
Grawemeyer Award in psychology (with Dr. Tversky) for my career was that, as I just mentioned, Amos Tversky and
revolutionizing the scientific study of decision making. I collaborated for a long time, beginning in 1969, and then
In 2011, the American Economic Association named Dr. [in 1978] he went to Stanford University and I went to the
Kahneman as a distinguished fellow, Bloomberg named him University of British Columbia. We went on collaborating for a
as one of the fifty most influential people in global finance, while after that, but it became very difficult for many reasons,
and Foreign Policy magazine recognized him as one of the mainly the physical separation. I think that together we were
world’s top global thinkers. In 2005, Dr. Kahneman was doing work that was better than either of us did separately. So
voted 101st among the 200 greatest Israelis of all time in the fact that we stopped working together was a major disap-
a poll conducted by the Israeli news website Ynet. He has pointment. I think I would have done better work if we had
been awarded honorary doctorates by numerous universities gone on working together, and probably so would he.
including the University of Michigan, Erasmus University Meir Statman: In your most recent book, Thinking, Fast
in the Netherlands, University of Paris, University of Milan, and Slow, you talk about the organizing principles of System 1
Harvard University, and The New School. and System 2.3 I was speaking some months ago to a group
In February 2012, Dr. Kahneman spoke with members of wealthy investors and business owners, noting the need to
of the Editorial Advisory Board of the Journal of Investment check intuition by the rules of science. One of the participants
Consulting about his investigations into decision making in said that he still trusts his gut much more than scientific evi-
the context of a dual-process model, loss aversion and risk dence. How can we persuade people to check their intuition?
tolerance, adversarial collaboration, and financial advisors’ And should we persuade people to check their intuition?

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Daniel Kahneman: I don’t know that you can persuade intuitions are products of heuristics of judgment and are
everybody. The confidence that people have in their intu- quite often mistaken.5 The problem is that even the mistaken
itions is a genuine feeling; it is not an opinion. You have intuitions come to mind with considerable confidence. It’s
the immediate feeling that your thinking is right, that your very difficult to distinguish between intuitions that reflect real
intuitions are valid, and it’s like something you see, an illu- skill and intuitions that don’t. It is not easy for an observer,
sion. People are very resistant to changing their minds about and even harder for the individual who has the intuition. We
their cognitive illusions. We’re much more willing to accept don’t know the boundary between skill and heuristic in our
visual illusions, but people really resist when you tell them own thinking.
that their thinking in a certain way is an illusion. It’s very dif- Ed Baker: So that makes this type of behavior very dif-
ficult to convince them. On the whole, the ideas of System 1 ficult to distinguish, that is, when it’s an example of skill and
and System 2 are penetrating, that is, there is more and more when it’s not?
readiness to accept them. However, it’s slow, and when they

“
conflict with people’s direct intuition, you’ll find they quite
frequently lose. Optimism also facilitates re-
Meir Statman: The people to whom I was speaking were
members of families who had established very successful siliency in the context of execution.
businesses. I was wondering whether their experience had
involved one or two decisions that went spectacularly well, However, we need to distinguish
which persuaded them to believe in a version of the law of situations in which optimism and
small numbers.4
Daniel Kahneman: Absolutely. It’s very clear that it confidence are useful from situa-

”
doesn’t take very much for people to think that there is a
pattern, and it doesn’t take many successes for people to tions in which they are not.
think that they are very, very smart, and it doesn’t take many
successes for others to think that a successful person has
been very smart. People can be lucky, and that will feed into
overconfidence. But even without luck, people are prone to Daniel Kahneman: In Thinking, Fast and Slow, I
overconfidence. described my collaborative work with Gary Klein6 on
Ed Baker: I have a slightly different question, but related determining whether you can trust intuitive thinking. The
to that. I picked up on one comment you made in your Nobel conclusion is that if you want to know whether you can trust
Prize autobiography, which I found to be just fascinating. In intuition, your own or somebody else’s, you shouldn’t ask
particular, you said that most highly cognitive performances about subjective confidence, because that can be very mis-
are intuitive. I wondered, when it comes to identifying skill, leading. Instead, you should ask about the probability that a
does that make it harder or easier? Is there something about person’s intuitions arise from genuine skill. For that, you have
this characteristic that one can identify, or is it really just to look at whether the world is sufficiently regular to support
unique from instance to instance? Is there a pattern that one skill, which is true for chess masters and for recognizing the
can see? emotion in your wife’s voice but probably isn’t true in the
Daniel Kahneman: What we call intuitive thinking refers stock market. Second, you have to ask whether the individual
to the ideas that come to mind quickly and without reflec- has had sufficient practice to acquire this skill. So confidence
tion, quite often automatically. You’re in a situation, and is not it. You’ve got to look from the outside. When a person
you know what to do or you know how to understand that makes a judgment, you have to ask what are the probabilities
situation. Most of the time, our intuitions are just fine. We that this judgment is well-founded given the nature of the
mostly run on what I call System 1 intuitively and with high world in which that individual operates and the nature of the
confidence and very successfully. That is true both in very practice that the individual has had.
simple matters—for example, recognizing a speaker’s emotion Ed Baker: Interesting, but there certainly are contexts
on the telephone from hearing one word, this is something in which confidence plays a dominant role in success, for
at which all of us are quite skilled. Intuition is often excellent example, in a leadership setting.
in complex tasks as well. We have learned hundreds of skills Daniel Kahneman: Absolutely. We reward confident
that actually are at the level of a chess master, except we don’t optimists. There is no question that, in the context of leader-
think of them that way. When we get highly practiced, we ship, somebody with high confidence is more likely to inspire
develop skills. The problem with intuition and with people trust in others and is more likely to attract resources that are
who want to trust their gut is that intuitions come with high needed for success. Optimism also facilitates resiliency in the
confidence. The confidence is justified when intuition is a context of execution. However, we need to distinguish situa-
product of skill, which people have acquired through numer- tions in which optimism and confidence are useful from situ-
ous experiences with immediate feedback. However, some ations in which they are not. Roughly speaking, confidence is

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very useful in the context of execution, that is, when you are do to their well-being? Is it possible that a good part of what
already committed to a course of action, you need to believe financial advisors do is increase investors’ well-being while
that you can do it. That will make you more resilient if things potentially diminishing their wealth?
go badly, and thereby improve the real chances of success. Daniel Kahneman: Those are two very different questions,
If I have a favorite football team, I would like those players so I’ll take them one at a time. We know from recent research
to be optimistic when they are on the field. In the context of that, beyond a certain income threshold, which is actually quite
decision making, however, I have absolutely no interest in my low—it’s about $70,000 per household, emotional happiness
financial advisor being an optimist. I would like him to be as doesn’t seem to increase at all. Now, life satisfaction probably
well-calibrated as possible. increases reasonably steadily with wealth. When people seek
Mark Anson: I’ve had experience working with pension more wealth, although they will never spend what they already
funds over the years, and it’s interesting to observe the group have, this is clearly because money is a proxy for something
psychology and herding7 that you see associated with large else. I mean, money is a proxy for ego satisfaction. So most of
institutional investors. At least I’ve observed it from time to these people are in it because they need success, and money
time with pension funds tending to move in the same direc- is just an index of success. That, I think, is the motivation for
tion at the same time. I noticed in your book that you talk many people. Actually, I think the people who are strictly moti-
about System 1 versus System 2 and the behavioral biases that vated by money rather than by success are mainly the poor and
can impact either of them. I was curious, from your point of the very poor. For most of us professionals, money is a proxy
view, do you find more behavioral bias embedded in a System 1 for something else, and that is certainly true for hedge fund
process versus a System 2? It seems like a System 2 process, managers. So that’s an answer to your first question.
which you refer to as a bit more analytical, might at times Your second question is a very interesting one—what is
have the potential to be lazy and just accept what the rest of the relationship between financial advising and the client’s
the herd is doing. Can you comment on that? well-being? Actually, I’ve worked with that question before. In
Daniel Kahneman: The way I analyze this in the book, fact, with a well-respected investment advisory firm, Andrew
most actions involve both systems. That is, System 1 quite Rosenfield8 and I were involved in devising a program for
often is the one that originates an idea or an impulse for an advising very wealthy investors. There you’re really more con-
action. Then System 2 quite often endorses it, without checking cerned with their well-being than with their wealth. Primarily
sufficiently. That happens a great deal. In addition, System 2 you want to protect them from regret, you want to protect
quite often lacks the necessary knowledge. So you can slow them from the emotions associated with very big losses. So you
yourself down, but mobilizing System 2 won’t do anything for end up focusing more on their emotions than on their wealth.
you if you don’t have the tools to understand the situation. Meir Statman: Can you give an example of how you
Slowing down is good when it allows you to deal with a situ- might have done this?
ation more intelligently. Slowing down won’t help when you Daniel Kahneman: That relates to another question, that
are out of your depth. is, how does one identify risk tolerance? Our thinking on this
Mark Anson: When people slow down, doesn’t that tend was that the issue is not so much tolerance for risk as it is tol-
to mean that they fall back in with the pack again, in that erance for losses. Tolerance for losses means that you have to
herding behavior that many have written about? know—the individual investor has to know and certainly the
Daniel Kahneman: I’m not at all sure of that. I would advisor has to try to know—how much loss the person will
attribute herding to a System 1 tendency. In situations of very be able to tolerate before he changes his mind about what he
high ambiguity, and when you have lost your confidence in is doing. Clearly, changing course by and large is not a good
your own ability to understand the world, then the tendency idea, and selling low and buying high is not a good idea. You
to do just what other people are doing is extremely power- have to anticipate regret and identify the individuals who are
ful. It’s also reinforced by social norms and by groups. If you very prone to regret. They’re not going to be very good clients
see other pension funds doing something and you don’t do for the financial advisor. If people are very prone to regret,
it, you will get severely punished if you lose for not following then you have to help them devise a plan that will minimize
the herd. So following the herd has an element of safety in it, their regret. For the very wealthy, emotion is clearly impor-
and it’s bound with System 1. I don’t think of it as primarily a tant in determining what policy is appropriate.
System 2 process. Herding is not necessarily something one Geoff Gerber: I remember hearing Amos Tversky present
does as the result of analysis. It is what one does when one’s the findings of your collaborative research at a University
confidence is impaired. of California, Berkeley, seminar on finance back in the early
Meir Statman: There are two areas that I hope you will 1980s. He introduced the concept of loss aversion bias9 that
not end this interview without addressing. One has to do you’re talking about, which, as you say, is the tendency to
with your work on well-being, and the other has to do with fear losses more than we value gains. The question from an
your work on fairness. Why do people with billions of dol- investment manager’s perspective or an investor’s perspective
lars—hedge fund managers as one example—want even more is does the implementation of stop-loss limits10 help alleviate
money? I know what it does to their wealth, but what does it the loss aversion bias?

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Daniel Kahneman: The main question that I have found Daniel Kahneman: Actually, this is a topic I haven’t
useful to ask when someone is very wealthy is how much thought about, so I don’t have a clear sense. In part, the need
loss is the individual willing to tolerate? That is, what fraction to hide fees comes from the fact that many of the advisors
of their wealth are they actually willing to lose? It turns out are frequently conflicted to some extent because if they’re
that fraction is usually not very large. That’s a very important associated with a firm that provides products, then there
parameter. How much do they really want to protect as much is a problem associated with fees. Advisors who are com-
as possible, and how much are they willing to consider losing? pletely hands-off, that is, those who are not involved with the
That varies a lot among individuals. By and large, the very products they are selling, probably should have no difficulties
wealthy mostly want to protect their wealth, and they’re will- explaining their fees and charging for their services. It’s those
ing to play with a small fraction of it. That is the fraction they who are in a more ambiguous position who are probably sen-
are prepared to lose, but it’s not a large fraction. So they’re sitive about their fees. I haven’t seen much discussion of the
loss averse, not risk averse as such. fairness of fees because clearly this is a competitive market,
Geoff Gerber: So you’re suggesting that setting a stop-loss and there is enough variability in the fees for individuals to
higher or lower depends on your willingness to accept a loss? make their own choices.
Is that a good approach? Ed Baker: Moving on to a different area, I was interested
Daniel Kahneman: For the individual who is very con- in asking about your new work in adversarial collaboration.11 I
cerned about losses, I think this is certainly a good approach. found that to be a fascinating turn of events in your life. What
That’s the major question you want to ask the investor. How motivated that? Have you found some interesting oppor-
much are you willing to lose? Then you have to take steps so tunities to do new creative work? How can this be applied?
that they won’t lose more than they are willing to lose. That’s It seems that if you could develop some systematic rules, it
in effect stop-loss policy. could be a major breakthrough in the way negotiations work.
Ed Baker: Could you in fact organize questions that I’m thinking, of course, in the area of government.
involve costs of insurance to see how much they’d be willing

“
to pay for insurance that would protect against losses?
Daniel Kahneman: That’s interesting. I hadn’t thought
I was just very struck by how
of it that way—in terms of insurance. Yes, that would be an
interesting approach. Also, people have to become aware of totally wasteful this is, because in all
the fact that by stopping their losses, they are giving up some
potential upside. Looking at the trade-off between the upside these exchanges nobody admits to
and the downside gives you a sense of their attitude toward
having made an error. It is very strik-
losses and what you should encourage them to do.
Meir Statman: You mentioned that people are willing to ing, and quite frequently it becomes

”
play with or lose some portion of their money. I don’t know if
you have in mind that they keep two mental accounts: one is an exercise in sarcasm.
money that is not to be lost, and the other is money that can
possibly be lost?
Daniel Kahneman: That is exactly what we have in mind. Daniel Kahneman: I got into adversarial collaboration
We actually had the individual construct two portfolios. One because there is a system in the scholarly literature where
is a portfolio that is designed mainly for safety, and the other people critique other people’s writings, and then there is a
portfolio is designed to take advantage of opportunities. The reply, and then there is a rejoinder. That’s the routine in scien-
relative size of the two portfolios represents one way of iden- tific publications. I was just very struck by how totally waste-
tifying loss aversion because with your riskier portfolio, that’s ful this is, because in all these exchanges nobody admits to
an amount you can consider losing. It’s not only two mental having made an error. It is very striking, and quite frequently
accounts. At least with some clients, we make this com- it becomes an exercise in sarcasm. It’s just foul actually. So
pletely explicit, that is, clients receive information about two having been involved in some controversy, I became very
accounts, about their safe account and their riskier account. interested in the possibility of trying to meet people who
This is a very natural way for people to think. don’t agree with me. All of us have a shared commitment to
Meir Statman: If I might move on to the issue of fairness, science, and we—at least in principle—also have a shared
where you’ve done a lot of work, perhaps I can frame my commitment to truth. That gives us some basis for working
question in the context of the fees that are charged by advi- together to achieve truth. Now it turns out that even among
sors. I think that financial advisors have more difficulty than scientists, the commitment to truth is—well, it’s a real com-
other professionals, say physicians, lawyers, or accountants, mitment—but emotion comes in. One of the striking things
in setting fees and justifying their fees. Advisors seem to be about adversarial collaboration—and I’ve had several—is
forever trying to hide their fees in one form or another. Can that at the end of the collaboration, nobody feels that he has
you speak to this issue of fairness? changed his mind much. That’s very typical.

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“
You asked whether adversarial collaboration could be
implemented in politics. The question is whether there is T h e re is ve r y little in f o r m a -
enough of a shared commitment, a shared goal, for people
to be interested in searching for compromise or in searching
tio n in adve r tis in g, an d any bo dy
for joint action. This clearly exists among scientists, but it’s wh o watch e s pro grams with l o a d s
much less likely to exist among true adversaries in the politi-
cal domain, except possibly in a situation of crisis when it o f adve r tis in g, s uch as th e Sup e r
would become natural for adversaries to collaborate. I’m not
very optimistic that adversarial collaboration can generally
B owl f o r example, wo uld be ha rd
be extended to areas other than science. I’ve had luck with it. pu t to f in d any in f o rmatio n ab o u t
I’ve had good experiences with adversarial collaboration, I’ve
avoided lifelong quarrels, and I have made friends. In sum, my any pro duct. It is ve r y s tr ik in g —
experience has been a good one, but adversarial collabora-
th e re is n o n e. It’s all appe alin g to

”
tion takes a lot of time and a lot of patience. It also sometimes
takes quite a bit of self-control not to lose your temper with dif f e re n t ty pe s o f e mo tio n s .
somebody who seems stuck on refusing to see the truth as
you see it. So it’s a mixed bag of experiences, and I’m not sure
how far it can go beyond science. Daniel Kahneman: I think that most people believe they
Let me add that there are two practices that quite probably are in the market to beat the market. If they are planning to
can advance or spread beyond science. One is, almost as a beat the market, they are willing to pay some price. If, in your
technique, to encourage adversaries to take each other’s point imagination, you’re going to beat the market by a lot, then
of view and to make a speech that is, as it were, for the other you become insensitive to fees. In order to become sensitive
side. That induces empathy, and it really helps you to under- to fees, it’s almost a precondition to accept that you’re very
stand what the other side is doing. That’s a very worthwhile unlikely to beat the market systematically, and that’s a dif-
exercise if you’re really interested in advancing cooperation. ficult realization for many investors. That relates to the other
The other practice that seems really useful is socializing. I question of why aren’t all investors in index funds. Clearly,
think one of the disasters in Washington is that apparently there has been an increase in the amount of money invested
there is now very little socializing across political parties, in index funds, but I read the statistic of 25 percent of assets
whereas thirty or forty years ago, it was a rule that adversar- somewhere. Is that correct?
ies would drink and smoke together and go to football games Meir Statman: At most, I would say.
together and so on. That is enormously important to mitigate Daniel Kahneman: This is clearly overconfidence at work,
adversarial relations, and we don’t have that now. and to some extent the people who are selling these services
Meir Statman: In politics, persuasion is the thing. It’s are themselves overconfident. I had a marvelous experience
less a matter of finding the truth than getting people to vote many years ago with a financial advisor, whom I actually
for you. I think there is an equivalent of that in the financial left—well, I had already left him when we had this conversa-
services industry, exploiting cognitive errors rather than tion. I had moved to a safer line of investments, and he called
countering them. For example, we see advertising that magni- me and said: “Look, what you are doing is stupid. We could
fies people’s overconfidence in their ability to beat the market, make a lot of money for you. You are limiting your gains to
rather than tamp it down. Can you speak to that? a fixed amount, and last year we had several funds that did
Daniel Kahneman: Obviously, there is a lot of pandering so much better than that amount.” Then I looked back at the
to System 1 in advertising. I don’t know if you have in mind letter he had written me a year earlier in which he recom-
the ads that encourage you to trade so as to beat the market mended specific funds. None of the funds he had recom-
and become rich. Those ads are clearly directed at overcon- mended was among those that actually made a lot of money a
fident people, and are intended to enhance their overconfi- year later. But he didn’t know it. He had no interest in lying to
dence. Most of advertisement is addressed to System 1, not to me, because I had already left him and he knew I wasn’t com-
System 2. There is very little information in advertising, and ing back. He was fighting for his own overconfidence. I think
anybody who watches programs with loads of advertising, there’s much more sincere overconfidence than lying among
such as the Super Bowl for example, would be hard put to the professionals who think they can beat the market, and so
find any information about any product. It is very striking— they convince investors, and investors think, “Here is a guy
there is none. It’s all appealing to different types of emotions. with a track record of five winning years,” and off they go.
Meir Statman: By one reliable estimate, U.S. investors Meir Statman: Obviously, cognitive errors get in the way,
would save more than $100 billion each year if they switched because the financial services industry is a great puzzle. In
to low-cost index funds. Why aren’t more investors using a world where people are smart—even if not rational—all
index funds? Why aren’t they more sensitive to the fees would move on to index funds. The question I come back to
involved? is the question of well-being. Is it possible that we underes-

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 THE MASTERS SERIES

timate the joy that people derive from attempts to beat the Daniel Kahneman: Of course, there are many questions
market? Or that we underestimate the desire for the hope of about the future, the future of research, and so on. I don’t
getting rich through their investments? believe in long-run forecasting, and I don’t believe that you
Daniel Kahneman: I see the question you are raising, can say the field is going in one direction or another. I have
and it’s a very interesting one. Clearly when people go to Las very little to say about where the field is going. Short-term,
Vegas to gamble, most of them are not going to get rich, and you can tell there is going to be more neuro-economics—
they know that they are more likely to lose than to win, but that’s fairly clear, because so many bright students are going
they are going for the entertainment and the excitement and into that field. The role of emotion in decision making is
the thrill and the possibility of winning. Whether people who going to be discussed, and there’s going to be more of it in the
are investing think of it as going to Las Vegas, I personally near future. Long-term, who knows?
doubt it very much. I don’t think it’s the same thing. They Meir Statman: One sentence in Thinking, Fast and Slow
don’t know that they’re gambling—they think they’re playing that struck and delighted me was one where you said that
a game of skill. you cringe when you hear people say that Amos Tversky and
Ed Baker: However, there are examples such as Warren you proved that people are irrational. Could you elaborate on
Buffett,12 and people see someone like that apparently making that? What is your sense of rationality? What does irratio-
money consistently. Do they just misassess the probability of nality mean to you? I know that I have been using the term
winning? Is that really what’s going on? “normal” to define the opposite of rational.
Daniel Kahneman: I think so. Clearly from the examples Daniel Kahneman: I’m delighted with that question, and
you see or read about, there are successful people. If you went I’m actually very pleased to talk about that. The word ratio-
by the proportion of successful and unsuccessful people that nal14 for me is a technical term. Rationality is defined in deci-
you see in the media or that you hear talked about, then suc- sion theory15 as logical coherence, and it’s very easy to test. In
cess overwhelms failure. Anybody who relies on what we call fact, a significant amount of research—and the research done
the availability heuristic13 is going to find support for his over- by Amos and me, specifically—was dedicated to showing that
confidence. That’s overconfidence, not a search for well-being. people are not rational by that definition. But to call people
The few who are in the market for the sheer excitement of it irrational makes me cringe because the meaning of irrational-
probably gamble small amounts, and know that they are in ity is associated for most people with emotion, with impulsiv-
Las Vegas. ity, with frothing at the mouth. Our research was concerned
Meir Statman: Perhaps, but if you ask people who drive a with cognitive biases; we did not deal with mistakes that
Lexus or Rolls Royce if they do it for status, they would surely people make that arise from emotional impulsivity. As I
deny it. They would say it’s because of the car’s high quality understand the word, what we studied was not irrationality. I
and so on. I wonder if investors lack introspection about their see a lot of System 1 influence, and System 1 is the emotional
wants. one, but I don’t see all that much irrationality.
Daniel Kahneman: To some extent, I think you are right. Ed Baker: On the other hand, you’ve resisted defining
There are two separate questions. First, do people know rationality, you said. If you were forced to come up with a
the odds? The best evidence suggests that they don’t know definition, what would it be?
the odds, but they are truly optimistic about the likelihood Daniel Kahneman: I think I just defined it. I accept the
of their winning. Second, when they play, when they are in definition of rationality as a technical term. I don’t use the
the market, do they by and large derive well-being from it? word rationality except as that technical term. I don’t say peo-
Well, that’s a complicated question, because if somebody is ple are irrational. I speak of reasonableness, I follow Richard
more sensitive to losses than to gains, then they don’t get Thaler in talking about Econs16 versus Humans, and I think
much well-being from the winning and losing. They get some Meir’s use of normal is the same general idea. I just don’t use
excitement, and they quite possibly are deluded about how the word much, except in its technical meaning. The so-called
much they are winning and losing. That is, people have selec- rational agent17 hypothesis is outlandish and completely
tive memories for their successes and failures, and they may implausible. No finite mind could satisfy the requirement
actually misremember their previous record and think that it of rationality. The bottom line is that I don’t need to define
is better than it really was. rationality, because it’s defined as a technical term.
Margaret Towle: It’s similar to 2008. When you ask Ed Baker: Is there some underlying condition, though,
people, nobody lost any money then. that leads to efficient markets?
Meir Statman: I lost money, I can assure you. Daniel Kahneman: I don’t know enough economics to
Margaret Towle: We’ve covered a wide range of top- answer that question. I could quote second-hand or third-
ics so far today, Dr. Kahneman, but are there other areas of hand that it doesn’t take many rational agents to have enough
interest that you think are especially relevant when it comes money to enforce market discipline and so on. But I don’t
to the investment industry as far as potential areas of research really know enough.
or areas that are unexplored now, given your conceptual Meir Statman: Can you elaborate on what you said in
framework? your book about prospect theory?18 You noted what pros-

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 THE MASTERS SERIES

pect theory did to counter expected utility theory,19 but you recent work in behavioral finance, in particular, be helpful in
also pointed out the shortcomings of prospect theory in forming market regulation?
being true to reality. I’m not sure if I’m quoting it correctly, Daniel Kahneman: I think there is no question about
but I have this quote in my mind from Amos Tversky that that. There are direct implications of behavioral economics
“elegance is for tailors.”20 and of the idea of bounded rationality24 for regulation. The
Daniel Kahneman: Amos attributed that quote to Albert idea of the rational agent model has two pernicious conse-
Einstein. I don’t know if he was right—I never checked. quences. One is that you don’t need to protect consumers
Meir Statman: Any quote where we don’t know the from themselves because they are rational, and therefore can
source, we attribute to either [John Maynard] Keynes21 or be trusted to make the choices that are best for them. So you
Einstein. In any event, would you comment on the fascination can oppose Social Security on the dual assumptions that peo-
we have with higher mathematics and formal models and the ple are rational and that they should bear the consequences of
field’s direction in terms of how it expresses itself? I know you their actions. However, I believe that regulation is essential to
don’t forecast long-term, but perhaps short-term? protect people from predictable mistakes. You have to do that
Daniel Kahneman: Clearly, people who know math- without abridging freedom, of course, but that can be done.
ematics have an advantage over people who don’t, because And then you need to protect consumers from actors in the
they speak a language that others don’t understand, whereas market that would deliberately exploit people’s ignorance and
psychologists, sociologists, and people in professions such as their intellectual sloth.
that—most of the social scientists—speak in a language that, Margaret Towle: This has been a most interesting discus-
even if they use a little jargon, everybody can understand. So sion. We really appreciate your taking the time to share your
mathematics is an exclusive club, and there is a certain pride views and talk with us. Thank you, Dr. Kahneman.
in belonging to it. It creates a mystique, and those who belong Daniel Kahneman: Thank you.
probably get a little more respect than they deserve. On the
other hand, I have seen examples where clear mathematical Endnotes
1
Richard H. Thaler (1945– ) is an economist and professor of behav-

“
ioral science and economics at The University of Chicago Booth
I was just very struck by how School of Business. He is best known as a pioneering theorist in
behavioral finance and for his collaboration with Daniel Kahneman
totally wasteful this is, because in all and others in further defining the field of behavioral economics and

these exchanges nobody admits to 2

finance.
Amos Tversky (1937–1996) was a cognitive and mathematical psy-
having made an error. It is very strik- chologist, a key figure in the discovery of systematic human cogni-
tive bias and handling of risk, and a longtime collaborator of Daniel
ing, and quite frequently it becomes

”
Kahneman. Their early work together focused on the psychology of

an exercise in sarcasm. prediction and probability judgment. The two went on to develop
prospect theory, which endeavors to explain irrational human
economic choices and is considered one of the seminal works of
thinking really improves the quality of psychological theory. behavioral economics. Six years after Tversky’s death, Dr. Kahneman
Amos Tversky was a master at it. He could use mathematics received the 2002 Nobel Memorial Prize in Economic Sciences for the
to think better. That’s not true of all mathematical psycholo- work he did in collaboration with Tversky. (The prize is not awarded
gists, but Amos really used mathematics to make himself think posthumously.) Kahneman told the New York Times in an interview
more clearly. There are other examples as well. In behavioral soon after receiving the honor (November 5, 2002): “I feel it is a joint
finance, for example, we have the demonstrations by Nicholas prize. We were twinned for more than a decade.”
Barberis22 of Yale University that one needs not only loss aver- 3
In psychology, dual process theory is used to explain how a phenom-
sion but also narrow framing23 in order to explain the behavior enon can occur in two different ways or as a result of two different
of individuals in the market. That was mathematical reason- processes (and in various mixtures of the two): an implicit (or auto-
ing. It can be very fruitful when used in conjunction with good matic) unconscious process and an explicit (or controlled) conscious
psychological intuition, so it is a very powerful tool. process. Daniel Kahneman further differentiated these two styles
Margaret Towle: We’re nearing the end of our time, Dr. of processing as System 1 and System 2. System 1 (or intuition) is
Kahneman, so I’ll ask you if there’s anything we haven’t cov- rapid, automatic, and effortless, usually with strong emotional bonds
ered that you’d like to discuss. included in the reasoning process. System 2 (or reasoning) is slower,
Daniel Kahneman: No, we have covered more than I know. deliberate, and subject to conscious judgments and attitudes.
4
Margaret Towle: Well, that’s due to collective intelligence, The law of small numbers describes the judgmental bias that can
I think, as far as the great questions that the group asked. occur when an assumption is made that the characteristics of a sam-
Ed Baker: I have one final question as to whether you ple population can be estimated from a small number of observations
have any thoughts for the regulators. Could any of your more or data points.

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 THE MASTERS SERIES

5 17
Heuristics of judgment are principles or methods used to potentially In economics and decision theory, a rational agent, which can include
simplify assessments or judgments of probability. In psychology, individuals, companies, or computer programs, has clear preferences,
heuristics are simple, efficient rules, hard-coded by evolutionary models uncertainty using expected values, and always chooses to
processes or learned, that are used to explain how people make deci- perform the action that results in the optimal outcome for itself from
sions and solve problems, usually when facing complex situations or among all feasible actions.
18
incomplete information. Although these rules work well under most Prospect theory describes the ways in which individuals make choices
circumstances, they can lead to systematic errors or cognitive biases. among probabilistic alternatives that involve risk or uncertainty and
Examples of heuristics of judgment include representativeness, avail- evaluate potential losses and gains. Prospect theory, which attempts
ability, and anchoring. to model real-life choices rather than optimal decisions, holds that
6
Gary A. Klein (1944– ) is a research psychologist noted for pioneer- individuals make decisions based on the potential value of losses and
ing the field of naturalistic decision making, focusing on the ability of gains (loss aversion) rather than the final outcome. The theory was
intuition to support human decision making in high-pressure circum- developed by Daniel Kahneman and Amos Tversky in 1979 as a psy-
stances, such as firefighting and medical emergencies. chologically more accurate description of preferences versus expected
7
Herding describes the phenomenon of individuals in a group uncon- utility theory.
19
sciously acting together without planned direction. In decision making, expected utility theory, which is based on ele-
8
Andrew Rosenfield, an economist and attorney, is managing partner mentary rules of rationality, addresses the analysis of choices among
of Guggenheim Partners, a financial services firm that provides wealth risky or uncertain prospects by measuring the value of various out-
and investment management services to high-net-worth clients, comes relative to respective probabilities, with the focus on the final
foundations, and endowments. He also is managing partner and chief outcome.
20
executive officer of The Greatest Good. “If you are out to describe the truth, leave elegance to the tailor.”
9
In economics and decision theory, loss aversion bias is a form of cogni- Attributed to Albert Einstein (1879–1955) as well as to Ludwig
tive bias that describes the tendency to strongly prefer avoiding losses Boltzmann (1844–1906), an Austrian physicist noted for advocating
to acquiring gains. Studies suggest that losses are twice as powerful for atomic theory at a time when it was still controversial.
21
psychologically as gains. Loss aversion was first convincingly demon- John Maynard Keynes (1883–1946) was a world-renowned British
strated by Amos Tversky and Daniel Kahneman. economist whose ideas, known as Keynesian economics, had a major
10
Stop-loss limits are orders placed with a broker to sell a security impact on theories of modern economics and politics as well as on
when it reaches a certain price. A stop-loss order is designed to limit an government fiscal policies.
22
investor’s loss on a security position in advance, minimizing emotional Nicholas C. Barberis (1971– ) is a professor of finance at the Yale
decision making. School of Management, where his research focuses on behavioral
11
Adversarial collaboration is described as “a good-faith effort by unlike finance, specifically using cognitive psychology to understand the
minds to conduct joint research, critiquing each other in the service of pricing of financial assets.
23
an ideal of truth to which both can contribute” on Dr. Kahneman’s TED Framing refers to the context in which a decision is made. An investor
speaker page, http://www.ted.com/speakers/daniel_kahneman.html. is said to use narrow framing when he makes an investment decision
12
Warren Buffett (1930– ) is an American investor, philanthropist, and without considering the context of his total portfolio. Together, nar-
chairman and chief executive officer of Berkshire Hathaway. Often row framing and loss aversion may provide a method for understand-
referred to as “the oracle of Omaha,” he was ranked by Forbes as the ing how individuals evaluate stock market risk by examining their
third-wealthiest person in the world, with a net worth of $44 billion, in evaluation of risk in experimental settings.
24
March 2012. In decision making, bounded rationality holds that the rationality of
13
The availability heuristic is a thought process that uses the ease with individuals is limited by the information they possess, their cognitive
which examples come to mind, or knowledge that is readily available, limitations, and the finite amount of time available to make a deci-
to make judgments about the probability of events. This can result in sion. Economic models typically assume that the average person is
a cognitive bias because the frequency with which examples come to rational and will, in large enough numbers, act according to prefer-
mind does not accurately reflect their actual probability. ences. The concept of bounded rationality revises this assumption to
14
In psychology, the term rational is used to denote the use of conscious account for the fact that perfectly rational decisions are, in practice,
thought processes to solve problems. often unfeasible because of the finite computational resources avail-
15
Decision theory involves identifying the values, uncertainties, and able for making them. Daniel Kahneman has proposed bounded
other issues relevant to decision making. By outlining a set of alterna- rationality as a model to overcome some of the limitations of the
tives and their potential consequences, decision theory can be used to rational agent model in economic literature.
help individuals make better-informed decisions.
16
Econs, a term coined by Richard Thaler, are the imaginary efficient References
individuals found only in economic theory who are able to weigh Kahneman, Daniel. 2002. Autobiography. http://www.nobelprize.org/
multiple options, forecast the consequences of each, and make logi- nobel_prizes/economics/laureates/2002/kahneman-autobio.html.
cal choices, as opposed to actual humans, who are illogical, prone to ———. 2003. Maps of Bounded Rationality: Psychology for Behavioral
generalize, biased in favor of the status quo, and more concerned with Economics. American Economic Review 93, no. 5 (December):
avoiding loss than making gains. 1,449–1,475.

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 RECENT RESEARCH

———. 2011. Thinking, Fast and Slow. New York: Farrar, Straus and Giroux. Thaler, Richard H., Amos Tversky, Daniel Kahneman, and Alan Schwartz.
Kahneman, Daniel, and Angus Deaton. 2010. High income improves eval- 1997. The Effect of Myopia and Loss Aversion on Risk Taking: An
uation of life but not emotional well-being. Proceedings of the National Experimental Test. Quarterly Journal of Economics 112, no. 2 (May):
Academy of Sciences 107, no. 38 (September 21): 16,489–16,493. 647–661.
Kahneman, Daniel, and Edwin E. Ghiselli. 1962. Validity and Nonlinear Tversky, Amos, and Daniel Kahneman. 1971. Belief in the Law of Small
Heteroscedastic Models. Personnel Psychology 15, no. 1 (March): 1–11. Numbers. Psychological Bulletin 76, no. 2: 105–110.
Kahneman, Daniel, and Gary Klein. 2009. Conditions for Intuitive Expertise: ———. 1974. Judgment under Uncertainty: Heuristics and Biases. Science
A Failure to Disagree. American Psychologist 64, no. 6 (September): 515–526. 185, no. 4157 (September 27): 1,124–1,131.
Kahneman, Daniel, and Amos Tversky. 1979. Prospect Theory: An
Analysis of Decision under Risk. Econometrica 47, no. 2 (March):
263–291.

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