Daniel Kahneman

Category: People Sub-Category: Scientist

When Michael Lewis decided to write a book (The Undoing Project) on the extraordinary collaboration between Israeli psychologists Daniel Kahneman and Amos Tversky, he turned to my graduate school professor, Dacher Keltner (to whom the book is dedicated), to guide his path. Dacher, as it happens, is especially well suited for this role as he is an uncommonly thoughtful, insightful, curious, and kind human. He also had the uniquely good fortune of having Tversky as a graduate school professor at Stanford and Kahneman as colleague at Berkeley. I never had the chance to meet Professor Tversky, but I got to meet Professor Kahneman twice: once at a “brown bag lecture” over lunch at Princeton when I was applying to graduate school, and again a couple years later after a lecture he gave at Berkeley. Both times were before he won the Nobel Prize in Economics, an honor that he would have shared with his collaborator if Tversky had lived until 2002.

My masters thesis, “Social Psychology in Financial Markets,” leaned heavily on the groundbreaking work that Kahnemen and Tversky (generally pronounced quickly and as one word, “KahnemanAndTversky”) did on decision-making. Should you want to dive into this work, which I highly recommend if so inclined, Thinking, Fast and Slow is an excellent place to start. Today’s piece won’t go deep on their famous Prospect Theory nor will it catalog the variety of heuristics we repeatedly employ and biases we predictably struggle to overcome when making decisions. These areas are rich for careful study, but they are simply too much for today. The punchline is that, when making financial decisions, psychological value does not necessarily equal strict monetary value. This directly contradicted the mainstream economic orthodoxy, put forward most elegantly by Professor Eugene Fama at the University of Chicago. Fama’s model stated that market prices are “right” because they reflect the collective, rational assessment of all available information. Kahneman and Tversky showed that, in fact, human decision-makers are not Spock-like supercomputers, they are, well, human.

As a graduate student, having never actually met a professional investor, I wondered how much relevance these competing theories had outside of academia, in the real world of Wall Street and financial markets. Today’s post is focused on an answer to that question, courtesy of Daniel Kahneman. Fast-forward to me as an enthusiastic 29-year old hedge fund kid in Hong Kong. I’d previously been in New York, as an investment banker at Morgan Stanley on a team that was buying stakes in hedge funds for the bank. When we acquired a hedge fund startup in Hong Kong, I was tapped to join it. Those were heady (frothy!) times as a massive Asian bull was in full swing, I was living in the Four Seasons (nice!), and our newly formed fund was sharing the 67th floor of Two International Finance Centre (then the second tallest building in China) with Warbug Pincus, the venerable private equity giant.

Our fund was raising hundreds of millions of dollars to invest in China, and there was one large New York investor (who, for confidentiality reasons, will remain unnamed) that I badly wanted to invest. After five in-depth meetings and calls with the key people on our team, their Chief Investment Officer (CIO) sent me a message saying he was coming to town and that he wanted to have lunch. Great news, I thought, and booked us a table at The American Club, high above Victoria Harbour. At lunch, after brief pleasantries, he jumped straight into his questions. By this point, I’d done hundreds of these meetings, knew all of the questions, had great answers queued up, and was fully in my element. However, his questions were different. They were aimed at the psychology and decision-making processes of our CEO and the other key members of the investment team. They focused on motivations, incentives, fears, and uncertainties. They also were hitting disconcertingly close to some of my own nagging concerns and reservations about how the fund would respond in challenging circumstances. As the conversation continued, I felt the chess board closing in around me. When he asked his last acutely probing question about a specific personality trait of our CEO, it was clear that the result of the lunch would be the opposite of what I’d hoped. I said that I’d answer his question, and that I also understood he would not be investing, but first, I had a question for him:

“How in the world did you know to ask the questions you asked? They were exactly the right questions to understand how decisions will be made here, and absolutely no one else has asked them.”

His eyes lit up and a big smile spread across his face. He explained that, at considerable expense, his firm had hired Daniel Kahneman to be his private tutor. On Friday afternoons, he would go to Kahneman’s Manhattan apartment, and they would simply talk. They would discuss investments, decisions, red-flags, and social psychology. The goal of these interactions was not to predict if the stock market would go up or down but instead to better understand how psychology impacts decision-making, and to try to sidestep mistakes that could be avoided using this knowledge. And there it was, the answer to the question I’d first wondered about as a student: Kahneman’s work was actively informing the decisions of this CIO as he skillfully and successfully managed a multi-billion dollar global portfolio!

For me, financial markets and investment decision-making have become an endlessly fascinating test-lab for applied social psychology, and the unique and valuable insights of Kahneman and Tvesky have most brightly illuminated my explorations. As a post-script, that fund in Hong Kong had an extremely difficult time in the Global Financial Crisis for exactly the reasons that the CIO who chose not to invest had correctly intuited about our CEO. Through the level-headed and sure-handed leadership of the fund’s President, who ably stepped in after the departure of the CEO, the fund was ultimately saved, investors got their money back with a modest return, and all ended up far better than it otherwise might have. However, my CIO friend saved himself and his investors from lots of heartache and headaches on an extremely bumpy roller coaster ride by understanding and acting on the wisdom of Daniel Kahneman.

One more thing…I simply cannot resist. Kahneman was born in Tel Aviv, but was a young boy in Nazi-occupied Paris. When receiving his Nobel Prize, and attempting to explain why he chose the field of psychology, he shared this unexpected and riveting memory:

It must have been late 1941 or early 1942. Jews were required to wear the Star of David and to obey a 6 p.m. curfew. I had gone to play with a Christian friend and had stayed too late. I turned my brown sweater inside out to walk the few blocks home. As I was walking down an empty street, I saw a German soldier approaching. He was wearing the black uniform that I had been told to fear more than others – the one worn by specially recruited SS soldiers. As I came closer to him, trying to walk fast, I noticed that he was looking at me intently. Then he beckoned me over, picked me up, and hugged me. I was terrified that he would notice the star inside my sweater. He was speaking to me with great emotion, in German. When he put me down, he opened his wallet, showed me a picture of a boy, and gave me some money. I went home more certain than ever that my mother was right: people were endlessly complicated and interesting.

Indeed!

And friends, that’s a wrap on post #7, only 2,493 to go. See you tomorrow with more from Hopefully Beneficial. Shalom and let’s keep going!