Unlock the secret to smarter investment decisions as Steve Davenport and I celebrate the groundbreaking and Nobel-winning work of Daniel Kahneman, the father of behavioral investing.
We dissect the intricate dance of human biases and investment decision-making. We bring Kahneman's legacy vividly to life, as we delve into the ways in which his psychology-rooted insights—particularly regarding loss aversion—continue to mold our financial pursuits and quest for happiness.
Picture this: your ancestors, primed for survival, have passed down instincts that still dictate today's economic behaviors. We navigate through these prehistoric impulses and their impact on our responses to modern crises, such as the recent pandemic. We also consider how AI might play a future role in management of our economic behaviors.
This episode is a compelling narrative that stitches together the fabric of our decision-making processes, from the stock market to retirement planning, revealing the often overlooked influence of behavioral economics on professional and retail investors alike.
Ending on a note of self-reflection, we embrace the concept of a utility function for happiness.. This episode is not just a journey through the mechanics of wealth accumulation but a guide to aligning financial decisions with personal contentment.
Straight Talk for All - Nonsense for None
Please check out our other podcasts:
https://skepticsguidetoinvesting.buzzsprout.com
Unlock the secret to smarter investment decisions as Steve Davenport and I celebrate the groundbreaking and Nobel-winning work of Daniel Kahneman, the father of behavioral investing.
We dissect the intricate dance of human biases and investment decision-making. We bring Kahneman's legacy vividly to life, as we delve into the ways in which his psychology-rooted insights—particularly regarding loss aversion—continue to mold our financial pursuits and quest for happiness.
Picture this: your ancestors, primed for survival, have passed down instincts that still dictate today's economic behaviors. We navigate through these prehistoric impulses and their impact on our responses to modern crises, such as the recent pandemic. We also consider how AI might play a future role in management of our economic behaviors.
This episode is a compelling narrative that stitches together the fabric of our decision-making processes, from the stock market to retirement planning, revealing the often overlooked influence of behavioral economics on professional and retail investors alike.
Ending on a note of self-reflection, we embrace the concept of a utility function for happiness.. This episode is not just a journey through the mechanics of wealth accumulation but a guide to aligning financial decisions with personal contentment.
Straight Talk for All - Nonsense for None
Please check out our other podcasts:
https://skepticsguidetoinvesting.buzzsprout.com
Welcome everyone to Skeptic's Guide to Investing. I'm Clem Miller and today we're going to talk about the recent passing of behavioral economics legend Daniel Kahneman. Steve Davenport and I will dig into the research which Daniel focused on and its ongoing effects as investors. Where do you start with? Daniel Kahneman, Steve?
Steve Davenport:Well, I start at the beginning and as an Israeli born psychology professor, he was really doing some interesting work and he became friends with Amos Tversky, also a psychologist, and it really is a little bit unusual when you talk about someone who wins a Nobel Prize in economics because he's never taken an economics class. I think that his work tells me a lot about similar things that we noticed when we discussed the life of Charlie Munger. I think that you know you start with some of the accolades. He won 23 honorary doctorates in the US and around the world, including one at your university in DC, Clem. He was the 2002 Nobel Prize in Economics and his real interesting part of what he did was to just question some of the underlying assumptions that people make about behavior and behavioral economics.
Steve Davenport:He's thought of as the father of behavioral economics. He really was interested in, first started studying hedonism and happiness and tried to think about how these things could be measured and how these things could be standardized, so that you could then go around the world and try to figure out how to put the systems in place. So first of all, I'd say his contribution and the way I look at his life is, he was understanding how decisions are made by humans and it feels like a very simple concept. But when you look at us, I think that I've always looked at us as economic animals who will make decisions that are good for themselves, based on the facts and information, but in reality, humans make a lot of decisions that are more instinctual, more like the caveman. So I think that understanding that basic difference of humans as unique decision makers really was the primary result of his life's work. I think, when you look at him, just like we looked at Charlie Munger and Warren Buffett, he worked for a critical period with fellow psychologist Amos Tversky. Kahneman and Tversky did several papers together on several topics, and it reminds me of Charlie and Warren because they both had their own characteristics, but they both figured out how to mesh together and work together in a way that makes the overall product and the overall result that much better. And so, just like you and I, clem, you know, when you team together two superstars, do you get an additive effect or do we subtract from each other? I like to think it's additive. So I think that one thing that he introduced is this concept of bias and how it can lead us down the wrong road. When we think about biases, we usually think, well, those exist for other people. We're perfect decision makers and we don't make those same human loyalty type of mistakes.
Steve Davenport:He then spent a lot of time on prospect theory, loss, aversion and happiness. I think that all three of these things have a great deal of influence on what we talk about when we're talking about investing. What are we investing for? What's the prospect of our investments? Results in 5, 10, 15 years? And how does our approach towards them lead us to better results or worse results? And I think the fact that he ultimately sits and develops a national or an international standard for happiness.
Steve Davenport:Again, the question about money isn't should you be doing something, it's how do you do it in a way that it aligned with your life plan and help you further that happiness goal? And then the last thing I think that's most interesting about Kahneman is that in the last six months to a year, we've been talking about AI and the implications for investing, and I look at what Kahneman was doing and saying and then I wonder well, gee, are we correct in the assumption that a man or human will make a better decision than AI will for investing If we have all these biases, are these biases wrapped up in our personal situation and therefore they're unique and important, or are they just biases that we have that really don't add much value? And therefore a more independent thinker and programmed to give you optimal results of the utility function that is your life, maybe that's what we should be thinking. So I think that his work and his ideas are something that we will be studying for the next 30 to 40 years wow.
Clem Miller:So there's really a lot to chew on there. And you know what's what? What I find interesting about him is that him and Tversky is that they started off in one field psychology and then he moved into another field economics and I think some of our most brilliant thinkers are those who have are those who are multidisciplinary. They might start off in one discipline and they move into another discipline, and certainly Daniel Kahneman was one of those figures and I think as a result you know that's, you know he ended up winning the Nobel Prize right in 2002.
Steve Davenport:I think it's a great lesson in terms of we always think of ourselves as outsiders. I've always been an engineer who was in finance and instead, you know, you start to realize, hey, some of the fundamentals and some of the disciplines of science, they can be helpful, they can also be harmful, because the world doesn't always work according to a set formula. So I think it's interesting that he was questioning, questioning, questioning the relationship and the decision making process, questioning the relationship and the decision-making process. And then we started to get into the science of what part of the brain are you using to think about this decision? And is that part of the brain typically associated with reactionary decision-making or is it the thoughtful, decision making part of your brain? And I think that when we thought of what he started in the 60s, you know, I don't think anybody imagined that we would get to the level of understanding of the human genome and other things that lead us to some of the interesting work that's going on today.
Clem Miller:So, Steve, I thought that economic animals, to use your term, were efficient in their decision making. My understanding of an economic animal is that it was more into thinking that human beings were more concerned about loss aversion than about sort of optimizing returns, which is, or optimizing risk, adjusted returns, to use an expression often used in finance, a loss aversion. And also, I've read that you know, I've certainly read that people are, you know, as decision makers, much more investment. Decision makers have roughly a two to one ratio of being concerned about loss aversion versus u pside return. So, yeah, that I mean two to one is a big ratio. So , Steve, once again you know why aren't economic animals efficient in their decision making?
Steve Davenport:Yes, I think we like to tell ourselves that we are right. We like to think of ourselves as having optimized every aspect of our life, but, as you can tell from my hair the fact I haven't shaved it's not really true. Right, if I was always optimized, I would look, start to look at things and say we're surrounded by unique characteristics that make optimization according to some standard function almost impossible to apply across economics, across countries, across different geographies. Geographies because, you know, an economy that's based on agriculture is very different than an economy based on technology versus an economy that's, you know, based on oil. These things all influence what type of people and what type of things are going to happen.
Steve Davenport:I still think of us Clem, and this is maybe because I've been watching too many Geico ads, but I'm like a caveman trying to stay alive. Food, heat, water those are the things that matter to me. We are loss adverse and we go back to that idea that we survived thousands of years because we were able to use rocks, use fire, use wheels, to, make our lives more consistent and provide that water and food and and be able to survive in the environments where, wild animals would come and take our food and potentially rip us to shreds. I think that today we're in a very different environment, but genetically we have that code in our DNA that's telling us hey, I don't know where my next meal is coming from, where do I go? And if it's raining, I get out of the rain. The rain's not going to hurt me, but I just still get out of it because I've had thousands programming of years of program.
Steve Davenport:So I think understanding where we came from is really important, so that when we think about what we're trying through our loss aversion technique, we need to sometimes take a step back, and I personally feel like I might focus too much on loss aversion and maybe my ratio is higher, but I think it really needs to think about and measure your internal utility function, and we are seeking risk for growth, and the reason we do that is that we understand that inflation and other things can eat away at the assets we have. And so I believe that when we look at ourselves as economic animals, I think we're probably taking a leap forward, that maybe we shouldn't all. We should realize first that we are going to try to survive as a civilization and then afterwards we're into some of the other things in the pyramid of needs and wants. So I think of myself still as a caveman.
Clem Miller:So, Steve, that leads to an interesting question, which is you know, if you look back at our recent experience with the pandemic, you know I'm sure somebody you know, some future Daniel Kahneman, is going to look back and say and do some research as to you know whether we were approaching the pandemic as cavemen, trying to be loss averse, or whether we were really trying to optimize. You know my guess whether we were really trying to optimize. My guess is not being a psychologist, but my guess is that we were certainly more thinking about loss aversion than we were about, you know, optimizing. You know which would have taken more more of an economic standpoint in terms of how we manage the pandemic.
Steve Davenport:Correct. I felt that we should have looked around and said what other countries in the world have had these and how have they handled them? We should have become researchers on Korea and Japan, because those two Asian countries, when they said, hey, we've got a pandemic, they all put their masks on. They all, you know, did the social distancing. They did these things that they had done before and they were familiar with. In the United States we never had a pandemic till, you know, since the Spanish flu in the early 1900s.
Steve Davenport:So we just didn't know how to react and I think, as cavemen, we said, okay, let's preserve ourselves first. Should we have said, hey, this is really important to preserve yourself. If you're one of these characteristics, I have diabetes, I'm overweight, I have these five health issues those would have been the people that you should have taken care of first. But instead we said everybody needs to stay away, everybody needs to close down. And I think it was a little bit of our democratic process, right where we say, look, we're going to treat everyone equally, where we say, look, we've got to treat everyone equally. Everyone's the same. If we disallow freedom for some, we can't disallow it for just a specific group, and that's what makes this whole discussion about how good are humans at making decisions and will AI be better at the heuristic decision process. I think it leads to some very interesting chat GPT type discussions where we think we can put a question in and we will get an answer that is relevant. Where are we making the worst decisions in our lives? Is it in health? Is it in money? Is it in health? Is it in money? Is it in relationships? I would like to say let's figure out what things are going poorly and then try to figure out how we optimize and minimize those things. What things do people do well and how do we maximize those properties? I think that what Kahneman does is he looks at things and says, hey, you need to watch out for this, this and this, and I think that using chat, gpt or AI, it may be like it's a pardon, you know, it's a part. So, since we're out of the caves, I have to believe that our loss aversion hurts us and therefore it's something that we should all watch out for.
Steve Davenport:I'm trying to change and trying to be more patient with my investing and I hope it. You know, I hope it has related to better results the last few years, and I hope it continues to. I also believe we're a little better at collaboration versus singular research on an idea. I believe that there is a benefit from two people sharing an idea, and I think that when I look at condominium diversity and I look at Charlie and Warren, I kind of believe that there's something there for everyone.
Steve Davenport:When you think about ideas, we think I'm going to go down this path and I journey down the path and maybe I go too far before I ask somebody else what they think, you know of the journey I'm going on, and I think it should be a way for us to put some guardrails on ideas that allow them to travel on the right road towards the right destination by having others collaborate, and I think collaboration is something that we need to investigate with AI. I hear about writers who give AI a topic and then they take the output and then add their own special flair to it.
Steve Davenport:Maybe, that's the way we should be using AI, instead of looking at the results and say look at us. We use AI for our summations and our capsules and our titles, and we know it's not perfect, so we try to collaborate with it to come up with some of the adjectives and some of the common phrases, but we want it to be unique to us and I think that's the future. It's collaboration. It's not just I accept the output from chat GPT, I accept the output from chat GPT. And then the last item I think about when I think about AI and this idea of behavioral economics is that we need to start to at least put down on paper what is the utility function for happiness.
Steve Davenport:I believe that everybody you know when you think about you know I used a lot of utility functions in my optimizations for quantitative management and you know you have alpha, you have tracking risk, you have taxes, and you combine that with any other frictions, like trading costs, and that's how you try to optimize your portfolio, like trading costs, and that's how you try to optimize your portfolio. And I believe that when we think about happiness, we've got relationships, we've got people we care about, we've got health, both mental and physical, and then I think that all of our efforts should really be on. Am I doing enough for myself in a way that's going to give me the economic, health and relationship benefits to optimize who I am and how I do on this journey? So the longest journey starts with a step and I agree you should still make that step, but I'm thinking about collaboration, and avoiding losses helps you to focus on a measurable result.
Clem Miller:So, Steve, what would be your biggest bias? And then I'll tell you mine. You go first.
Steve Davenport:I think that we are all products of a very imperfect education system and an imperfect support system in the classroom and at home. And I think your IQ, your intellectual quotient, your EQ, your emotional quotient and your physical quotient all are unique parts of who you are, so they lead you towards biases when we needed biases to help us evolve, and I think that today we still need biases to help us evolve, because I believe that what will come out of COVID will be this realization that interaction and socialization are a bigger part of our life than we ever realized and that by isolating we created more depression and more instability. But it's hard to look at because it doesn't show up on a list of diseases or a list of you know, ailments. But I think loneliness will be the thing that will come back as one of the biggest byproducts of COVID. And for your original question, my answer would be loss aversion. I think that I tend to look minimize, minimize, minimize that loss aversion, and I need to probably be a little more thinking about my return optimization.
Clem Miller:Yeah, I guess my biggest bias would be I look around and I get excited about new themes, new opportunities, and I purposefully try my very best to stay rational when there seems to be exciting opportunities out there. And so you know, you've noticed, you know, my skepticism about things like, you know, bitcoin or AI or renewable energy or ESG. You know these things, you know, have some excitement for me, but I think that you know, some of that excitement is really irrational and I have to pull myself back and restrain myself and, you know, stay true to some degree of uh, of process, uh, you know, using quantitative and to some degree qualitative, but not, you know, not get myself uh over my skis and thinking about, you know, and getting too excited about themes.
Steve Davenport:Yeah, I think that we talked about sector neutrality and we try to be sector neutral for that very reason. If the S&P is, you know, 30%, 25% in technology, and you look at it and you say I got two and a half percent positions, that's 10 to 12 positions, okay, you have to make some. You know you can fill in the first five or six probably pretty easily. Seven, eight, nine, get a little tougher and then you look at who you're leaving off the list when you're talking about 10, 11, 12.
Steve Davenport:And that's why I think it creates that little bit of discipline for you that you don't say I want to own all 20 of these tech names. And you know you say I feel really good and, yes, you will feel good when the growth is there and the tech does well, but you will, you will feel pain when it doesn't. And that's where I think you know I come at it from the standpoint of avoiding the pain. That's where I think I come at it from the standpoint of avoiding the pain. But then I also get I probably get a little less joy when the returns are really strong for tech. But I'm willing to live with that because I believe that balance is the key.
Clem Miller:So, basically, this loss aversion shows up to a large degree in your asset allocation.
Steve Davenport:Yes, and I think it's. When I think about it, clem, I'm usually seeing clouds on the horizon and I think about managing risk from avoiding negative returns. I look at it relative to the benchmark and I look at it as how am I doing? Versus inflation and no inflation plus rate. I think that all three are good benchmarks, but they can't always be the one that drives your decision. We are going to lose money, sometimes because the economy is going to go negative during recessions. Therefore, companies are going to earn less and the multiple you apply to those earnings is going to have to bring it down. So I think there's you know there's a lot of good reasons why you know the caveman helps, but there are also reasons why, as Conum approved, you need to keep them under control a little bit.
Steve Davenport:Asset allocation is a major decision for most advisors and clients and I think that when we look at it, we say this client should probably be in 80-20. But the client has lived their whole life living in a 60-40 world. So how do you get that client to either accept more risk or understand the risk he's taking, or try to minimize his regret if the returns go up too much? So I believe that's the real area where, as advisors, we need to step forward, understand the client's biases where they came from, where they're going, what they have in terms of their wants and needs and then we use new research and information to try to make better decisions, like the 401k decision. When you let employers put a 401k in place and the employee needs to take an active moment to do something about it, meaning to get rid of it, more and more people sign up for 401ks and their overall retirement results are better. That's a case where we had a behavior people weren't signing up because it just involved a little bit of work. We do the work for them, we pre-sign them up. When they join a company, all of a sudden, their results are immediately better because they kind of know inherently that it's good for them, but they just weren't willing to do the work to set it up.
Steve Davenport:So I think that when I look at allocation, first you need to make, do the work to set it up. So I think that when I look at allocation, first you need to be in the game, and then it's a question of how you play the game. So I think that there's. You know, as an industrial engineer, you think about two things effectiveness and efficiency. Effectiveness is choosing the right things. Efficiency is doing those things well. Effectiveness is choosing the right things. Efficiency is doing those things well.
Steve Davenport:And so, when you look at the general decision making, I think it's effective to have 60% to 80% in what I would call risky assets equities, and it's very efficient to do that with a four or five basis point index fund, because you're not paying a lot and you get a lot of exposure. Can you do better and try to do better Absolutely? And that's why we try, with individual management, to create what I'll call core portfolios, portfolios that are containing the best names. So I understand why people have biases and why people are in the wrong allocations, and I think it's really about trying to get people to understand those frictions and those biases and then come up with maybe something that's a little bit better decision not an optimal decision, because I think optimal is so relative that it's really hard to come up with the best one for everyone. What's?
Steve Davenport:your feeling about behavioral economics and its influence.
Clem Miller:Well, I think you know certainly it has managers. Many of them think about behavioral economics as one aspect of their philosophy and process. Many of them do especially on the value side of the equation not necessarily so much on the growth side and they're always looking. Those who are applying behavioral economics are always thinking in terms of the market mispricing stocks, overvaluing stocks, undervaluing stocks and they try to exploit these mispricings. So, yeah, I think behavioral economics has had considerable influence over the investment community, that is, the professional investment community. I think that retail investors really don't understand too well how they're being affected by behavioral economics and I think that this whole mean stock thing as well as crypto. There's a lot of behavioral economics involved in driving those retail decisions and I just don't think retail investors know that they're being subject to this behavioral exploitation. To look at it from that standpoint, I think you're right.
Steve Davenport:It's hard to look at Charlie Munger and have him say staying away from your portfolio, trading less, is the right decision, but you can prove through time that less turnover leads to usually better results. And I think that less loss aversion will lead to higher returns, especially for women, who tend to be more conservative and as women investors, they have a longer lifespan. They have the likelihood that their wages are going to be lower than a similar man. Therefore, if you get a longer lifestyle life and you have less earnings and you have disruption for children or family members, those things all mean that you have to make a little bit better decision on terms of loss aversion and how much exposure you have to risk anything in the mailbag so, um, hmm, are there, um so, steve, are there any books on this process, uh, on this topic, which we should read to maybe understand it better?
Steve Davenport:well daniel condom. His most famous book is Thinking Fast and Slow, and it's definitely a great read for anybody in this topic because I think it allows you to realize how instinctual some decisions and reactions are versus acting. So you want to be acting versus reacting. You don't want to have these stimuli kind of push you towards a decision as a chess player with a clock in a game you constantly battle. Is your decision good versus is it perfect? And then you try to weigh how much they strengthen your position and how much they benefit you for the long term and I'll tell you. You can sit there for a while and go through the permutations of five moves ahead, 10 moves ahead, and then you realize I don't know what his response could be completely different and not one of the choices I have. So, yes, I think that when we analyze our own thinking, no-transcript.
Clem Miller:Okay, so you know thanks.
Clem Miller:I would just say well, I would just say, as far as I'm concerned, you know, I've read a number of things about behavioral economics. I don't think there's a single and I've read that book, thinking Fast and Slow, but you know, I don't think there's any single book that I would recommend on the topic, any single book that I would recommend on a topic. Rather, what I do is I look at a number of books about value investing, about growth investing, about quality investing, and you know there are some books you know I can recommend and maybe we'll do this on a future podcast books about, you know, sort of, you know, interviewing particular managers and getting some insights from them, and I certainly would want to do that on a future podcast, and mispricing of securities is certainly something that is discussed in those books. So, yeah, so I would say, you know, let's stay tuned for a future podcast discussing how different managers look at. I'll give you a pass.
Steve Davenport:I'll give you a pass for today, but your homework, should you choose to accept it as to come back. Maybe when we're talking to Fraser next week we'll we'll go around the room and say what's our best investment book of all time.
Clem Miller:Right? Which which leads me to to to ask you around the room and say what's our best investment book of all time? Right? Which leads me to ask you Steve, we do have Fraser Rice on next week. Can you tell us a little bit about Fraser?
Steve Davenport:Fraser is an expert on all things planning and taxation for clients. Long-term and understanding how families can control and manage their assets between generations is a huge step in the next level of investing. Once you understand you have assets and then you satisfy your needs with those assets, then you take the next step in terms of how should I involve my children, how should I be involved in my grandchildren's lives, and ultimately you want to try to make those decisions and structures, put them in place so that you're one minimizing that taxation but also doing something to improve the utility of happiness for a family. I think Fraser is very good at looking at complex families and in situations and providing insights that makes the overall plan match what the overall needs and wants are for a family, so I think it'll be great to have him, yeah.
Clem Miller:So, steve, why don't you quickly summarize what we discussed today? Sure.
Steve Davenport:Like Charlie Munger, there is much to learn from Daniel Kahneman's life and his leadership. One challenge ideas. He challenged the ideas of biases and thinking and thought. These animals are not economic animals, they're not as efficient as we originally thought. Humanity is, by definition, not perfect. Therefore, I think that we have to take that viewpoint when we start looking at individuals and say we know they're going to make an imperfect decision, but how do we minimize the level of imperfection? We prioritize strengths and mistakes, but not necessarily that we probably focus too much on the mistakes, and maybe that's what we take from Daniel Kahn. Understand your utility function. There's a utility for happiness that would equal your safety plus your economics, plus your economics, plus your health, physical and mental plus friendships, family and friends. I think that if you think about that utility function, you don't have to have the coefficients exactly right and the magnitudes may be off for different people, but thinking about happiness first will start you on a path towards ultimately leading you to more happiness.
Steve Davenport:So, Steve I know.
Clem Miller:I would just say I totally agree with your, your second, your last point about you know the happiness function, so I totally agree with that. So, Steve, thank you very much for all of your insights today. Very much for all of your insights today, and we hope everybody enjoyed this episode of Skeptic's Guide to Investing. Thanks everybody for listening, Thanks everyone.