The fiery relationship between Daniel Kahneman and Amos Tversky sparked the development of trading psychology that has influenced economic decision making since the 1970s.
In 1968 the two little-known Israelis, Kahneman and Tversky, were studying at the Hebrew University of Jerusalem. Initially, the two social scientists didn’t care for each other.
They argued. “Brilliant talk, but I don’t believe a word of it,” Kahneman told Tverseky after listening to him give a seminar. But their perseverance paved the way for what is now known as behavioural economics.
The two were opposites: Tverseky was a confident optimist but aloof. Kahneman was more cautious but was intellectually fired in Tverseky’s company. Both were grandsons of rabbis from Eastern Europe.
Quick decisions under pressure
Danny Kahneman had worked with the Israeli Defence Force while Tversky had been a paratrooper. “In tank warfare,” Kahneman said later, “the speed at which one can decide on a target and act on that decision makes the difference between life and death.”
As a survivor of Nazi-occupied France – at one point hiding in a chicken coop with his family, aged seven – Kahneman knew plenty about risk.
What had become increasingly apparent to Kahneman and Tversky in their early research was that humans were poor at acting on risk and uncertainty objectively. Especially under stress.
Perceptions of losses
One of their key perceptions was that potential losses loom bigger than profits for many – a key insight for trading psychology.
Even if you accept a loss, the two Israeli scientists understood that loss aversion – a refusal to cut your losses and move on – can compromise you, even ruin you. Yet losses are a part of life for traders – they’re the rational consequences of the job, and of being human.
Digging into loss aversion further Tversky and Kahneman pursued how decision making and risk was managed through a variety of ‘framing’ responses.
They tagged it, in 1979, Prospect Theory. It went onto win a Nobel Prize for Kahneman in 2002, though not for Tversky who died in 1996 of melanoma at home in Stanford, aged 59.
Prospect Theory attempted to untangle the contradictions and tensions in how people respond to financial choices.
For example, you might travel on public transport in bad weather for half-an-hour to save £25 on a £100 coat – but not make the same journey to save £25 on a £10,000 car. Even in good weather. Yet the same amount of money saved (or not saved) is at risk.
Prospect Theory has many sides to it but how decision-making got framed was key to Tversky and Kahneman’s research.
Another bias Tversky and Kahneman took a hard look at was Gambler’s Fallacy (which also goes under the Monte Carlo fallacy moniker).
This bias has its roots in pre-revolution French gambling dens. It’s the idea that if something happens often in a certain period it will happen less in future.
For example, a woman gives birth over four years to three babies, all girls. Conventional probability suggests a fourth male baby is a good bet.
Patterns in trading psychology
Transfer this reasoning to the roulette table or trading psychology and it’s potentially ruinous. That’s because each spin of the ball, Tversky and Kahneman argued, is a completely independent event.
Yet the Gambler’s Fallacy is to believe things even out. This (lack of) reasoning goes the other way with another bias, Hot Hand Fallacy i.e. winning streaks.
In other words, the human brain loves to seek out patterns. Even when there is no rational reason to believe them.