Daniel Kahneman, on the Fallible Human:

Born 1934 in Tel Aviv, Israel. Currently teaching at Princeton University

"The world makes much less sense than you think. The coherence comes mostly from the way your mind works. "

The creator of behavioural economics 

If it seems strange to you that the winner of the 2002 Nobel Prize for Economics has claimed never to have taken an economics class in his life, then that’s a pretty good place to start pondering on what a strange subject economics can be. Kahneman, one of the most influential economists of all, is a psychologist and a social theorist.

Oh no, not another cross-disciplinarian?

Sorry, yes. But what made Kahneman famous was that he challenged the logical economic models of his predecessors, simply by pointing out that people are irrational, emotional, prejudiced and sometimes superstitious – and that these human traits lead them to make decisions that defy so-called economic logic.

Sounds woolly. Details?

The history of economics – from Plato to Adam Smith, from Marx to Keynes and Hayek – has centred on the belief that humans are essentially rational, and that they will behave in predictable ways whenever confronted by certain situations. But in the free-thinking sixties and seventies it became possible for Kahneman to protest that the reliability of the traditional economic models was being thwarted by free will. And that if you wanted to predict behaviour, you might as well start by studying the mind.
Born into a Lithuanian Jewish family, Kahneman spent his early years in Paris before leaving for the newly-created Israel in 1948. His psychology teaching at the Hebrew University of Jerusalem created an opening at Harvard in 1968, and after the 1970s he hardly strayed from the USA.

Prospect Theory

Kahneman spent most of the 1970s working with Amos Tversky on a series of seminal articles concerning the irrational way in which humans make their judgements. It was the their Prospect Theory, published in 1979, that famously showed how people choose between probabilistic alternatives that involve risk. And it was that same paper that kick-started the development of behavioural finance as a field of serious economic study.

Kahneman observed that if, for example, one fund manager has had three above-average years in a row, then many people will conclude that he’s better than average even though the data period is far too small to justify this conclusion. And he noted that if the first four tosses of a coin come up heads, they’ll conclude, irrationally, that the next toss is likely to be tails. That’s the wacky human brain for you.

Prospect Theory was what scooped the 2002 Nobel Economics Prize for the non-economist. By that time Kahneman had long since moved forward into new fields, such as his equally famous Toward a Positive Theory of Consumer Choice, published in 1980 together with Richard Thaler, and something called Hedonic Psychology.

Hedonic? You’re kidding me

Nope. Hedonics, according to Kahneman, is “the study of… feelings of pleasure and pain, of interest and boredom, of joy and sorrow, and of satisfaction and dissatisfaction……the whole range of circumstances, from the biological to the societal, that occasion suffering and enjoyment." Oh dear. But wait, this new-age rambling has a point. Honestly. Because people make their economic decisions on the basis of this flawed stuff.

Kahneman was also heavily into the way that people’s ideas about other people conditions their expectations of the future and their ability to compare their fates. The "focusing illusion", he said, will make a Midwesterner feel that he’s less well blessed than a Californian just because Los Angeles has better weather: the fact that other factors might override the sunshine state’s advantages will not weigh heavily enough on his assessment.



This Week’s Most Read

Latest IFA Magazine Podcast Episodes

Keep updated on the most important financial events 

Make sure you are an informed

wealth professional..

Adblock Blocker

We have detected that you are using

adblocking plugin in your browser. 

IFA Magazine