Tuesday, March 31, 2015

Five Lessons from Daniel Kahneman

Professor Daniel Kahneman, who shared the Nobel prize in Economics in 2002 for his work on psychology (Prospect Theory), is probably the greatest living Behavioral Economist (after all, he invented the subject!).

Here are five lessons on the Markets derived from the work and words of Mr Kahneman.

1. Be Humble.

source:  http://www.bloomberg.com/

Kahneman's research has shown that since we use overconfident, highly emotional logic in making investment decisions, the best approach is often the simplest.
Ironically, Kahneman defers to his certified financial planner for portfolio advice, Harold Evensky of Evensky, Brown & Katz in Coral Gables, Florida.
At the beginning of a lecture in Chicago on May 2, after introducing himself as a psychologist and insisting he wasn't an economist, Kahneman glanced down at Evensky sitting in the first row and quipped nervously, ``I'm intimidated by my financial adviser, he knows how little I know.''
A little humility goes a long way in successful investing. You don't need a Nobel Prize under your belt to discover that. 

2. Think in Broad Terms

source:  http://www.bloomberg.com/

Kahneman said he believes our brains are hard-wired for small decisions imbued with optimism. ``Optimism is a force in capitalism, it may be the engine of capitalism.''
The best way of cultivating the better angels of our nature? Kahneman suggests making fewer financial decisions and focusing on wealth from a big-picture perspective of several decades instead of following the market day to day.
``We are more risk neutral when we think broadly than when we think small.'' 

3.  Aim to beat inflation

source:  http://www.bloomberg.com/

By investing in index mutual funds and U.S. Treasury Inflation-Protected Securities, or TIPS, Kahneman said his primary retirement planning focus is beating inflation and maintaining steady income -- a strategy much at odds with Wall Street's mantra of maximizing return.
Keep it simple and aim to beat inflation. Don't try to beat the market. Kahneman's approach is an efficient path that won't get derailed by psychology. When it comes to investing, less is more. And if you try to do more, you'll often end up with less. 

 4. Keep track, maintain scores, be a scorekeeper.

In the financial world there is no scorekeeping mechanism. People can come on media and say whatever they want, there is no way to hold them accountable. On this subject, David says:

I think there is really too little scorekeeping. It's sort of astonishing when you think of those CFOs coming in year after year, and making predictions that make no sense, and they come back next year with the same level of confidence. There is no improvement. There is some absence of scorekeeping there.

5. Accept that we do not know the future

Many people now say they knew a financial crisis was coming, but they didn't really. After a crisis we tell ourselves we understand why it happened and maintain the illusion that the world is understandable. In fact, we should accept the world is incomprehensible much of the time. 

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