Kahneman & Tversky: the beginning of trading psychology
13:37, 11 August 2017
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
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.
Gambler’s Fallacy
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.
Modesty
While proud of their work both men were modest. After winning a five-year MacArthur Foundation fellowship in 1984 Tversky said, dryly, much of their work had already been mined by "advertisers and used car salesmen”.
But Tversky’s remark showed how cognitive biases had embedded themselves into many consumers’ lives, with little real awareness.
Randomness – it’s everywhere
In Kahneman’s 2011 book Thinking, Fast and Slow he describes a visit to a Wall Street investment firm where traders were prized for their ability to ‘read’ financial markets. But a key part of Kahneman’s thesis was the role of randomness in staff performance.
“They were really quite angry when I told them that,” he told the Evening Standard. “But the evidence is unequivocal — there is a great deal more luck than skill involved in the achievements of people getting very rich.”
Kahneman hadn’t just taken aim at sloppy credit taking. His book, tilting at self-help as well as behavioural economics, was a warning shot towards the financial investing and trading community – a community notorious for over-rewarding itself.
Corporate decision-taking and remuneration (think CEO and investment bankers’ pay) remains a hot topic. So Kahneman’s work was as relevant in 2011 as it had been when he and Tversky were starting out in the late 1960s.
Money versus happiness
Coursing through the veins of both men’s work since the beginning were the perils of overconfidence. Kahneman and Tversky, back in 1979, had identified a cognitive bias they proposed as Planning Fallacy.
In a nutshell it’s when we underestimate the costs of a project, but over-estimate the benefits. From ill-advised corporate decisions in the press to personal ‘real life’ stories. Politics is full of planning fallacies, as are wars. It’s a very human failing.
Writing in his 2011 book Kahneman described Planning Fallacy as possibly the most significant bias. But by now he was looking hard at two other related planning fallacy zones: happiness and money.
“Everyone wants to make more money,” he told Der Spiegel in 2012 “and yet the salary level – at least above a certain threshold – has no influence whatsoever on emotional happiness, although life satisfaction continues to rise with income.”
Kahneman thought that income threshold was around $75,000. “Below that, it makes a substantial difference…No matter if you are sick or going through a divorce, everything is worse if you're poor.”
End-of-relationship bias
Kahneman would have been the first to admit that people can adapt, given the chance. But his relationship with Tversky failed this test.
The two fell out some time before Tversky died. According to Michael Lewis’ book The Great Undoing Project, which plotted the complex relationship of the two psychologists, Tversky’s wife Barbara described their relationship breakdown as “worse than a divorce”.
Tversky had attracted more publicity of the pair. He had also become increasingly critical of Kahneman’s ideas.
“Kahneman,” wrote Lewis, “thought Tversky should have been more supportive, both publicly and privately. Tversky thought Kahneman was being too sensitive. This difference in perspectives led to tension and anger.
More than just trading psychology
Despite their innate knowledge of loss aversion and other cognitive frailties, their own relationship was unable to avoid breakdown. Yet their legacy was far bigger than their own relationship.
The two men enabled anyone to re-think rationally every life decision and judgement and profit from it. Even more, they encouraged us to think about how we think.