At that time, I had just launched Value Research’s first print magazine, Mutual Fund Insight. We did a cover story on Kahneman and Tversky’s work titled ‘Out of Your Mind?’ The sub-head of the article was ‘Behavioural economics suggests that, for investors, understanding their own psychology is even more important than understanding the markets.’ Stated formally, with the weight of the Nobel behind it, this sounds like a new concept and, as a part of economics, it definitely is. Yet, instinctively, every investor already knows this. When you first hear about it, it immediately strikes a chord and feels obvious.
In fact, the core ideas of behavioural economics are so intuitive that they have been part of popular wisdom for centuries, if not millennia. Proverbs and aphorisms across cultures are replete with admonitions against the very cognitive biases that Kahneman and Tversky identified and studied. ‘Don’t put all your eggs in one basket’ warns against the lack of diversification. ‘Cut your losses and ride your profits’ cautions against the sunk cost fallacy. ‘A bird in hand is worth two in the bush’ illustrates the concept of loss aversion. Kahneman and Tversky took this folk wisdom and subjected it to rigorous scientific investigation. Through clever experiments and data analysis, they were able to demonstrate the pervasiveness of these biases and show how these systematically affect our decisionmaking, often in ways that are detrimental to our own interests.
For those who invest, this work is particularly relevant. The financial markets are filled with uncertainty, risk and emotional stress—conditions that make our cognitive biases stronger. Understanding these biases is the first step towards avoiding their bad effects. So, by being aware of our tendency to overreact to losses, follow the herd, or be overconfident of our judgements, we can make a conscious effort to counter these biases and make more rational investment decisions.
Of course, the implications of behavioural economics go beyond individual investors. The insights from this field are increasingly being applied to other aspects of personal finance, from retirement savings plans to health insurance. By understanding how people make decisions, rather than how perfectly rational agents would, people’s decisions may be guided, or ‘nudged’. This is not something I’m enthusiastic about. It’s essentially covert manipulation. Those doing the nudging may not have your best interests at heart or may not be very competent.
This field is best used as a personal tool to understand and improve decision-making. By becoming aware of our own biases and mental shortcuts, we can take steps to counteract them when it matters most. This is especially crucial in personal finance and investing, where the consequences of irrational decisions can be severe and long-lasting. By cultivating self-awareness and learning to recognise when our emotions and biases are swaying our judgement, we can become better investors and stewards of our own financial well-being. That, I believe, would be the greatest tribute to the groundbreaking work of Kahneman and Tversky.(The author is CEO, VALUE RESEARCH)