Thinking, Fast and Slow (Daniel Kahneman)

Thinking, Fast and Slow is a 2011 book by Nobel Memorial Prize winner in Economics Daniel Kahneman which summarizes research that he conducted over decades, often in collaboration with Amos Tversky. It covers all three phases of his career:
- his early days working on cognitive bias,
- his work on prospect theory, and
- his later work on happiness.

The book's central thesis is a dichotomy between two modes of thought :
- System 1 is fast, instinctive and emotional;
- System 2 is slower, more deliberative, and more logical.
The book delineates cognitive biases associated with each type of thinking, starting with Kahneman's own research on loss aversion. From framing choices to substitution, the book highlights several decades of academic research to suggest that people place too much confidence in human judgment.


Contents
1 Prospect theory
2 Two systems
3 Heuristics and biases
3.1 Anchoring
3.2 Availability
3.3 Substitution
3.4 Optimism and loss aversion
3.5 Framing
3.6 Sunk-cost
4 Choices
5 Rationality and happiness
5.1 Two selves


The basis for his Nobel prize, Kahneman developed prospect theory to account for experimental errors he noticed in Daniel Bernoulli's traditional utility theory. This theory makes logical assumptions of economic rationality that do not reflect people’s actual choices, and does not take into account behavioral biases.

One example is that people are loss-averse: they are more likely to act to avert a loss than to achieve a gain. Another example is that the value people place on a change in probability (e.g. of winning something) depends on the reference point: people appear to place greater value on a change from 90% to 100% (going from high probability to certainty) than from, say, 45% to 55%, and place the greatest value of all on a change from 0% to 10% (going to a chance of winning from no chance). This despite that all three changes give the same increase in utility. Consistent with loss-aversity, the order of the first and third of those is reversed when the event is presented as losing rather than winning something: there, the greatest value is placed on eliminating the probability of a loss to 0.

Two systems

In the book's first section, Kahneman describes the two different ways the brain forms thoughts:
System 1: Fast, automatic, frequent, emotional, stereotypic, subconscious
System 2: Slow, effortful, infrequent, logical, calculating, conscious

Kahneman covers a number of experiments which purport to highlight the differences between these two thought processes, and how they arrive at different results even given the same inputs. Terms and concepts include coherence, attention, laziness, association, jumping to conclusions and how one forms judgments.

Heuristics and biases

The second section offers explanations for why humans struggle to think statistically. It begins by documenting a variety of situations in which we either arrive at binary decisions or fail to precisely associate reasonable probabilities to outcomes. Kahneman explains this phenomenon using the theory of heuristics.

Kahneman uses heuristics to assert that System 1 thinking involves associating new information with existing patterns, or thoughts, rather than creating new patterns for each new experience. For example, a child who has only seen shapes with straight edges would experience an octagon rather than a triangle when first viewing a circle. In a legal metaphor, a judge limited to heuristic thinking would only be able to think of similar historical cases when presented with a new dispute, rather than seeing the unique aspects of that case. In addition to offering an explanation for the statistical problem, the theory also offers an explanation for human biases.

Anchoring

The “anchoring effect” names our tendency to be influenced by irrelevant numbers. Shown higher/lower numbers, experimental subjects gave higher/lower responses. Experiment: experienced German judges proposed longer sentences if they had just rolled a pair of dice loaded to give a high number.

Availability

The availability heuristic is a mental shortcut that occurs when people make judgments about the probability of events by how easy it is to think of examples. The availability heuristic operates on the notion that, "if you can think of it, it must be important." The availability of consequences associated with an action is positively related to perceptions of the magnitude of the consequences of that action. In other words, the easier it is to recall the consequences of something, the greater we perceive these consequences to be. Sometimes, this heuristic is beneficial, but the frequencies that events come to mind are usually not accurate reflections of the probabilities of such events in real life.

Substitution

System 1 is prone to substituting a simple question for a more difficult one. In what Kahneman calls their “best-known and most controversial” experiment, “the Linda problem.” Subjects were told about an imaginary Linda, young, single, outspoken and very bright, who, as a student, was deeply concerned with discrimination and social justice. They asked whether it was more probable that Linda is a bank teller or that she is a bank teller and an active feminist. The overwhelming response was that “feminist bank teller” was more likely than “bank teller,” violating the laws of probability. (Every feminist bank teller is a bank teller.) In this case System 1 substituted the easier question, "Is Linda a feminist?" dropping the occupation qualifier. An alternative view is that the subjects added an unstated implicature to the effect that the other answer implied that Linda was not a feminist.

Optimism and loss aversion

Kahneman writes of a "pervasive optimistic bias", which “may well be the most significant of the cognitive biases.” This bias generates the illusion of control, that we have substantial control of our lives. This bias may be usefully adaptive. Optimists are more psychologically resilient, have stronger immune systems, and live longer on average than more reality-based opposites. Optimism protects from loss aversion: people's tendency to fear losses more than we value gains.

A natural experiment reveals the prevalence of one kind of unwarranted optimism. The planning fallacy is the tendency to overestimate benefits and underestimate costs, impelling people to take on risky projects. In 2002, American kitchen remodeling was expected on average to cost $18,658, but actually cost $38,769.

To explain overconfidence, Kahneman introduces the concept he labels What You See Is All There Is (WYSIATI). This theory states that when the mind makes decisions, it deals primarily with Known Knowns, phenomena it has already observed. It rarely considers Known Unknowns, phenomena that it knows to be relevant but about which it has no information. Finally it appears oblivious to the possibility of Unknown Unknowns, unknown phenomena of unknown relevance.

He explains that humans fail to take into account complexity and that their understanding of the world consists of a small and not necessarily representative set of observations. Furthermore, the mind generally does not account for the role of chance and therefore falsely assumes that a future event will mirror a past event.

Framing


Framing is the context in which choices are presented. Experiment: subjects were asked whether they would opt for surgery if the “survival” rate is 90 percent, while others were told that the mortality rate is 10 percent. The first framing increased acceptance, even though the situation was no different.

Sunk-cost

Rather than consider the odds that an incremental investment would produce a positive return, people tend to "throw good money after bad" and continue investing in projects with poor prospects that have already consumed significant resources. In part this is to avoid feelings of regret.

Choices

In this section Kahneman returns to economics and expands his seminal work on Prospect Theory. He discusses the tendency for problems to be addressed in isolation and how, when other reference points are considered, the choice of that reference point (called a frame) has a disproportionate impact on the outcome. This section also offers advice on how some of the shortcomings of System 1 thinking can be avoided.

Rationality and happiness

Evolution teaches that traits persist and develop because they increase fitness. One possible hypothesis is that our conceptual biases are adaptive, as are our rational faculties. Kahneman offers happiness as one quality that our thinking process nurtures. Kahneman first took up this question in the 1990s. At the time most happiness research relied on polls about life satisfaction.

Two selves

Kahneman proposed an alternate measure that assessed pleasure or pain sampled from moment to moment, and then summed over time. Kahneman called this “experienced” well-being and attached it to a separate "self". He distinguished this from the “remembered” well-being that the polls had attempted to measure. He found that these two measures of happiness diverged. His major discovery was that the remembering self does not care about the duration of a pleasant or unpleasant experience. Rather, it retrospectively rates an experience by the peak (or valley) of the experience, and by the way it ends. Further, the remembering self dominated the patient's ultimate conclusion.

Kahneman demonstrated the principle using two groups of patients undergoing painful colonoscopies. Group A got the normal procedure. Group B, unknowingly received a few extra minutes of less painful discomfort after the end of the examination, i.e., more total discomfort. However, since Group B’s procedure ended less painfully, the patients in this group retrospectively minded the whole affair less.

“Odd as it may seem,” Kahneman writes, “I am my remembering self, and the experiencing self, who does my living, is like a stranger to me.”


http://en.wikipedia.org/wiki/Thinking,_Fast_and_Slow

Why even experts must rely on intuition and often get it wrong

There have been many good books on human rationality and irrationality, but only one masterpiece. That masterpiece is Daniel Kahneman’s Thinking, Fast and Slow.

Kahneman, a winner of the Nobel Prize for economics, distils a lifetime of research into an encyclopedic coverage of both the surprising miracles and the equally surprising mistakes of our conscious and unconscious thinking. He achieves an even greater miracle by weaving his insights into an engaging narrative that is compulsively readable from beginning to end. 

Thinking, Fast and Slow, by Daniel Kahneman

Kahneman presents our thinking process as consisting of two systems. System 1 (Thinking Fast) is unconscious, intuitive and effort-free. System 2 (Thinking Slow) is conscious, uses deductive reasoning and is an awful lot of work. System 2 likes to think it is in charge but it’s really the irrepressible System 1 that runs the show. There is simply too much going on in our lives for System 2 to analyse everything. System 2 has to pick its moments with care; it is “lazy” out of necessity.

Books on this subject tend to emphasise the failings of System 1 intuition, creating an impression of vast human irrationality. Kahneman dislikes the word “irrationality” and one of the signal strengths of Thinking, Fast and Slow is to combine the positive and negative views of intuition into one coherent story. In Kahneman’s words, System 1 is “indeed the origin of much that we do wrong” but it is critical to understand that “it is also the origin of most of what we do right – which is most of what we do”.

http://www.ft.com/cms/s/2/15bb6522-04ac-11e1-91d9-00144feabdc0.html#axzz2jwvK7LJC

7 Controversial Investing Theories

When it comes to investing, there is no shortage of theories on what makes the markets tick or what a particular market move means. The two largest factions on Wall Street are split along theoretical lines into adherents to an efficient market theory and those who believe the market can be beat. Although this is a fundamental split, many other theories attempt to explain and influence the market - and the actions of investors in the markets. In this article, we will look at some common (and uncommon) financial theories.

Efficient Market Hypothesis
Very few people are neutral on efficient market hypothesis (EMH). You either believe in it and adhere to passive, broad market investing strategies, or you detest it and focus on picking stocks based on growth potential, undervalued assets and so on. The EMH states that the market price for shares incorporates all the known information about that stock. This means that the stock is accurately valued until a future event changes that valuation. Because the future is uncertain, an adherent to EMH is far better off owning a wide swath of stocks and profiting from the general rise of the market.

Opponents of EMH point to Warren Buffett and other investors who have consistently beat the market by finding irrational prices within the overall market.

Fifty Percent Principle
The fifty percent principle predicts that, before continuing, an observed trend will undergo a price correction of one-half to two-thirds of the change in price. This means that if a stock has been on an upward trend and gained 20%, it will fall back 10% before continuing its rise. This is an extreme example, as most times this rule is applied to the short-term trends that technical analysts and traders buy and sell on.

This correction is thought to be a natural part of the trend, as it's usually caused by skittish investors taking profits early to avoid getting caught in a true reversal of the trend later on. If the correction exceeds 50% of the change in price, it's considered a sign that the trend has failed and the reversal has come prematurely.

Greater Fool Theory
The greater fool theory proposes that you can profit from investing as long as there is a greater fool than yourself to buy the investment at a higher price. This means that you could make money from an overpriced stock as long as someone else is willing to pay more to buy it from you.

Eventually you run out of fools as the market for any investment overheats. Investing according to the greater fool theory means ignoring valuations, earning reports and all the other data. Ignoring data is as risky as paying too much attention to it; so people ascribing to the greater fool theory could be left holding the short end of the stick after a market correction.

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Odd Lot Theory
The odd lot theory uses the sale of odd lots – small blocks of stocks held by individual investors – as an indicator of when to buy into a stock. Investors following the odd lot theory buy in when small investors sell out. The main assumption is that small investors are usually wrong.

The odd lot theory is contrarian strategy based off a very simple form of technical analysis – measuring odd lot sales. How successful an investor or trader following the theory is depends heavily on whether he checks the fundamentals of companies that the theory points toward or simply buys blindly. Small investors aren't going to be right or wrong all the time, so it's important to distinguish odd lot sales that are occurring from a low-risk tolerance from odd lot sales that are due to bigger problems. Individual investors are more mobile than the big funds and thus can react to severe news faster, so odd lot sales can actually be a precursor to a wider sell-off in a failing stock instead of just a mistake on the part of small-time investors.

Prospect Theory (Loss-Aversion Theory)
Prospect theory states that people's perceptions of gain and loss are skewed. That is, people are more afraid of a loss than they are encouraged by a gain. If people are given a choice of two different prospects, they will pick the one that they think has less chance of ending in a loss, rather than the one that offers the most gains. For example, if you offer a person two investments, one that has returned 5% each year and one that has returned 12%, lost 2.5%, and returned 6% in the same years, the person will pick the 5% investment because he puts an irrational amount of importance on the single loss, while ignoring the gains that are of a greater magnitude. In the above example, both alternatives produce the net total return after three years.

Prospect theory is important for financial professionals and investors. Although the risk/reward trade-off gives a clear picture of the risk amount an investor must take on to achieve the desired returns, prospect theory tells us that very few people understand emotionally what they realize intellectually. For financial professionals, the challenge is in suiting a portfolio to the client's risk profile, rather than reward desires. For the investor, the challenge is to overcome the disappointing predictions of prospect theory and become brave enough to get the returns you want.

Rational Expectations Theory
Rational expectations theory states that the players in an economy will act in a way that conforms to what can logically be expected in the future. That is, a person will invest, spend, etc. according to what he or she rationally believes will happen in the future. By doing so, that person creates a self-fulfilling prophecy that helps bring about the future event.

Although this theory has become quite important to economics, its utility is doubtful. For example, an investor thinks a stock is going to go up, and by buying it, this act actually causes the stock to go up. This same transaction can be framed outside of rational expectations theory. An investor notices that a stock is undervalued, buys it, and watches as other investors notice the same thing, thus pushing the price up to its proper market value. This highlights the main problem with rational expectations theory: it can be changed to explain everything, but it tells us nothing.

Short Interest Theory
Short interest theory posits that a high short interest is the precursor to a rise in the stock's price and, at first glance, appears to be unfounded. Common sense suggests that a stock with a high short interest – that is, a stock that many investors are short selling – is due for a correction. The reasoning goes that all those traders, thousands of professionals and individuals scrutinizing every scrap of market data, surely can't be wrong. They may be right to an extent, but the stock price may actually rise by virtue of being heavily shorted. Short sellers have to eventually cover their positions by buying the stock they've shorted. Consequently, the buying pressure created by the short sellers covering their positions will push the share price upward.

The Bottom Line
We have covered a wide range of theories, from technical trading theories like short interest and odd lot theory to economic theories like rational expectations and prospect theory. Every theory is an attempt to impose some type of consistency or frame to the millions of buy and sell decisions that make the market swell and ebb daily. While it is useful to know these theories, it is also important to remember that no unified theory can explain the financial world. During certain time periods, one theory seems to hold sway only to be toppled the next instant. In the financial world, change is the only true constant.

Why investors behave the way they do

Why investors behave the way they do
Published: 2009/04/01

Learning from other market players’ mistakes; analysing how and what they think, can help an investor emerge as a winner in the market

In recent years, behavioural finance has been gaining grounds in trying to explain the financial anomalies in the stock market. These anomalies, which cannot be addressed by traditional financial theory such as the market efficiency theory may sound purely theoretical, but you cannot brush aside the need to understand the psychology of investors as it plays a big part in driving the stock market.

What is Behavioural Finance?


Behavioural finance is the study to explain the financial behaviour from the psychological aspect. Over the years, market psychologists have discovered that the two primary emotions that drive investors' risk-taking behaviour are hope and fear. There are a few key behavioural concepts that will help us to understand why some of us behave in certain ways when it comes to making investment decisions. In this article, we talk about four of such concepts:

* Regret theory


Regret, a simple enough concept to understand by any layman, refers to the emotional experience that one goes through when confronted with the wrong decision that he or she has made. It manifests itself in the form of pain when one feels responsible for not doing the right thing. When you look back at your investment history, try to recall the state you were in when you missed the chance to cut losses or missed the opportunity to buy a stock that you knew you should have bought because it was considered a good buy. Try and remember how you felt when the price of that particular stock that you did not buy increased subsequently. This emotion often becomes embedded in someone's mind in such a way that it regulates his or her future actions and decisions.

As a result, most investors make it a habit to avoid selling a loss-making stock and instead hope that the price will rebound eventually - all this, to avoid the feeling of regret. They would much rather make a paper loss than admit that they have made a mistake. In some cases, where the bad decisions happen to be recommended by their financial advisers, investors will put the blame on the advisers to avoid regret.

* Prospect theory

Prospect theory developed by Daniel Kahneman and Amos Tversky (1979), states that "we have an irrational tendency to be less willing to gamble with profits than with losses". Kahneman and Tversky found that when confronted with the choice between accepting a sure loss and taking a chance, most people will choose the latter. This phenomenon is called "loss aversion", which basically means that in general, people hate to lose. So, when faced with a situation involving loss, they become risk takers; they take the chance even if there is only the slightest hope of not having to lose.

On the other hand, when presented with a sure gain, they usually become risk-averse. Investors who behave this way tend to mark their stocks to the price that they originally paid to secure them and not to market. As such, they aim to get even before closing out a position. This type of investors usually ends up holding on to their loss-making stocks for far too long, which may very well prove detrimental to them in the end.


* Overconfidence

It is human nature for us to over-estimate our abilities and shower ourselves with a little too much confidence, i.e, overconfidence. Studies show that investors are often overconfident when it comes to their ability to predict the market's direction. Oddly enough, this is something that is more prominent among novice investors. Compared to experienced investors, those who are new to the market tend to set higher return expectations and end up being overwhelmed by the unfavourable outcome. As a result of overconfidence, some investors tend to trade too frequently only to get unsatisfactory returns or worse yet, losses. With the convenience of online trading, some even quit their full-time jobs to do day trading, thinking that they have the ability to predict the market and earn fast money. These are the people that usually end up getting burned if they do so without proper understanding of what they have been buying and selling, especially when the market is highly volatile.


* Anchoring


This is a behavioural phenomenon in which people tend to extrapolate the past into the future, putting heavier weight on the recent past. At times, when there are new announcements from companies, analysts fail to adjust their earnings forecast for the companies to reflect the latest information due to the anchoring effect. As a result, they land themselves with a few surprises when positive news become more positive and vice versa.

What has been discussed above are a few common behavioural phenomena experienced by investors that are useful to know. By understanding the psychology behind investors' behaviours, you can learn to recognise mistakes and avoid making such mistakes yourself. Learning from other market players' mistakes; analysing how and what they think, can help you emerge as a winner in the market.

Securities Industry Development Corp, the leading capital markets education, training and information resource provider in Asean, is the training and development arm of the Securities Commission, Malaysia. It was established in 1994 and incorporated in 2007.

http://www.btimes.com.my/Current_News/BTIMES/articles/SIDC9/Article/


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Behavioural Finance

Behavioral Finance

By Albert Phung

Whether it's mental accounting, irrelevant anchoring or just following the herd, chances are we've all been guilty of at least some of the biases and irrational behavior highlighted in this tutorial. Now that you can identify some of the biases, it's time to apply that knowledge to your own investing and if need be take corrective action. Hopefully, your future financial decisions will be a bit more rational and lot more lucrative as well.

Here is a summary:

• Conventional finance is based on the theories which describe people for the most part behave logically and rationally. People started to question this point of view as there have been anomalies, which are events that conventional finance has a difficult time in explaining.
  
• Three of the biggest contributors to the field are psychologists, Drs. Daniel Kahneman and Amos Tversky, and economist, Richard Thaler.
  
• The concept of anchoring draws upon the tendency for us to attach or "anchor" our thoughts around a reference point despite the fact that it may not have any logical relevance to the decision at hand.
  
• Mental accounting refers to the tendency for people to divide their money into separate accounts based on criteria like the source and intent for the money. Furthermore, the importance of the funds in each account also varies depending upon the money's source and intent.
  
• Seeing is not necessarily believing as we also have confirmation and hindsight biases. Confirmation bias refers to how people tend to more attentive towards new information that confirms their own preconceived options about a subject. The hindsight bias represents how people believe that after the fact, the occurrence of an event was completely obvious.
  
• The gambler's fallacy refers to an incorrect interpretation of statistics where someone believes that the occurrence of a random independent event would somehow cause another random independent event less likely to happen.
  
• Herd behavior represents the preference for individuals to mimic the behaviors or actions of a larger sized group.
  
• Overconfidence represents the tendency for an investor to overestimate his or her ability in performing some action/task.
  
• Overreaction occurs when one reacts to a piece of news in a way that is greater than actual impact of the news.
  
• Prospect theory refers to an idea created by Drs. Kahneman and Tversky that essentially determined that people do not encode equal levels of joy and pain to the same effect. The average individuals tend to be more loss sensitive (in the sense that a he/she will feel more pain in receiving a loss compared to the amount of joy felt from receiving an equal amount of gain).
  

Table of Contents
1) Behavioral Finance: Introduction
2) Behavioral Finance: Background
3) Behavioral Finance: Anomalies
4) Behavioral Finance: Key Concepts - Anchoring
5) Behavioral Finance: Key Concepts - Mental Accounting
6) Behavioral Finance: Key Concepts - Confirmation and Hindsight Bias
7) Behavioral Finance: Key Concepts - Gambler's Fallacy
8) Behavioral Finance: Key Concepts - Herd Behavior
9) Behavioral Finance: Key Concepts - Overconfidence
10) Behavioral Finance: Key Concepts - Overreaction and Availability Bias
11) Behavioral Finance: Key Concepts - Prospect Theory
12) Behavioral Finance: Conclusion