Nobel Prize-Winning Economist Explains How to Dramatically Improve Your Investment Performance
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Over the years, I've heard variations of the above response countless times whenever I've asked investors if they could beat the market. This composite response illustrates perfectly a main theme from Daniel Kahneman's Thinking, Fast and Slow. All of us – whether you're Warren Buffett or a struggling day trader – tend to overestimate our own investing abilities, while being extremely capable of assessing the weaknesses in others. Grasping this simple insight alone could dramatically improve your investment performance.
Being more humble isn't just an admirable personality trait – it can literally save you money. Below are nine investing insights from Nobel Prize Winner Daniel Kahneman's classic book Thinking, Fast and Slow:
1. "The best we can do is a compromise: learn to recognize situations in which mistakes are likely and try harder to avoid significant mistakes when the stakes are high."
Here, Kahneman is saying that we too often rely on our intuition and routine thinking for big decisions when we should actually slow down and become more analytical. This is especially true of those investors who are quick to trust their gut and overestimate their pattern recognition skills when deciding to buy or sell a particular stock.
Kahneman helps us better understand our thought processes by using the framework of System 1 thinking and System 2 thinking. The former operates automatically and quickly "with little or no effort and no sense of voluntary control." System 2, on the other hand, "allocates attention to effortful mental activities that demand it." Quite simply, System 1 is fast thinking, and System 2 is slow thinking. For investors, it's very important to know that System 1 is our default thinking style, and it can be a "machine for jumping to conclusions." Knowing this will encourage you to try to shift to System 2 when faced with a difficult decision.
2. "There is general agreement among researchers that nearly all stock pickers, whether they know it or not – and few of them do – are playing a game of chance."
Kahneman is skeptical about whether it's possible for ordinary investors to beat the market. As an academic steeped in statistics and economics, he points to 50 years of research that shows "the selection of stocks is more like rolling the dice than like playing poker."
Obviously, many of us might disagree, and that's fine. I still believe it's important to consider his view on this issue, however. Anyone who truly thinks they can beat the market, should be able to provide evidence of that skill by objectively analyzing their returns over a long timeframe. System 1 thinking is quite good at allowing you to fool yourself into thinking you might be better at stock picking than you really are.
3. "Most of us view the world as more benign than it really is, our own attributes as more favorable than they truly are, and the goals we adopt as more achievable than they are likely to be. We tend to exaggerate our ability to forecast the future, which fosters optimistic overconfidence. In terms of its consequences for decisions, the optimistic bias may well be the most significant of the cognitive biases."
Here again, we see how our System 1 thinking can play tricks on us. According to Kahneman, we often have a very unrealistic sense of our abilities and future prospects. This may explain why so many political and financial analysts are out there confidently making bad predictions on a daily basis.
The interesting part of this quote, for me, is Kahneman's take on optimism. He believes that being optimistic is a good thing to be – many entrepreneurs are more confident than mid-level managers, according to one study, for example. The danger, Kahneman argues, is that optimists tend to underestimate risks. This might be a good thing for spurring action, but might not always be the best thing for your portfolio.
4. "Closely following daily fluctuations is a losing proposition, because the pain of the frequent small losses exceeds the pleasure of the equally frequent small gains. Once a quarter is enough for individual investors. In addition to improving the emotional quality of life, the deliberate avoidance of exposure to short-term outcomes improves the quality of both decisions and outcomes."
This is one of the most helpful pieces of advice for investors in the entire book. Kahneman points to compelling research showing that checking individual investments on a frequent basis will lead to poor decision making. So why not save time and improve performance by turning off the daily market noise?
5. "The research suggests a surprising conclusion: to maximize predictive accuracy, final decisions should be left to formulas, especially in low-validity environments."
This quote is potentially very helpful for investors. Remember, Kahneman believes that stock picking is a classic "low-validity environment." So he'd likely argue that an inconsistent investing process would hurt performance over the long run. For illustration purposes, your belief that you know exactly when to increase (or decrease) your cash allocation might be a delusion that is hurting your overall returns.
If Kahneman is right about this, then relying on rules could be helpful. Putting money to work every single month, for example, regardless of what the market appears to be doing at that particular moment could be a smart technique. Holding stocks for five or even 10 years without selling could also be wise.
6. "Stories of how businesses rise and fall strike a chord with readers by offering what the human mind needs: a simple message of triumph and failure that identifies clear causes and ignores the determinative power of luck and the inevitability of regression. These stories induce and maintain an illusion of understanding, imparting lessons of little enduring value to readers who are all too eager to believe them."
I know I've been guilty of this many times in the past. We see a successful business from the past, and assume that's the magic formula for the future. Kahneman challenges us to be more skeptical. The excellent management book The Halo Effect makes a similar point.
Kahneman believes the key variable that is never considered by observers is "luck." Because luck is so important, "the quality of leadership and management practices cannot be inferred reliably from observations of success." Another important principle is regression to the mean. He notes a study of Fortune's "Most Admired Companies" showing that the worst-rated companies actually earned higher stock returns than the most admired firms over a 20-year timeframe.
7. "Success = talent + luck; Great Success = a little more talent + a lot of luck."
These formulas illustrate an important theme in the book. Kahneman feels that luck "plays a very large role in every story of success." A big challenge for investors, of course, is distinguishing between skill and luck. I've noticed that the most successful investors rarely acknowledge the latter as playing any role whatsoever until they have a bad year.
8. "The core of the illusion is that we believe we understand the past, which implies that the future also should be knowable, but in fact we understand the past less than we believe we do."
As a former history teacher, I believe this to be true. Our knowledge of the past is imperfect at best, and yet, we often make important decisions based on this imperfect understanding.
This insight is very important for investing. Is 2014 really like 1938? Or is it more like 2007? Does that mean you should sell or buy stocks or load up on gold? Kahneman would urge you to be careful here -- each of us has an "almost unlimited ability to ignore our ignorance."
9. "The satiation level beyond which experienced well-being no longer increases was a household income of about $75,000 in high-cost areas...The average increase of experienced well-being associated with incomes beyond that level was precisely zero."
This is such a great insight for me. Beyond a certain point, earning more money won't make you any happier. For investors, it's encouraging to know that growing a realistic pot of capital over a long timeframe will likely be enough to result in a happy retirement.
I can't recommend Thinking, Fast and Slow enough to all investors. For me, it's one of the best investing-related books that I've ever read.
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