Daniel Kahneman passed away on 27th March and your LinkedIn feed is probably filled with people telling you why Kahneman’s book “Thinking, Fast and Slow” is the best book ever written.

And there’s no denying it’s a great book. But it also draws heavily from the research he conducted in the preceding decades. Research that won Daniel Kahneman, a psychologist with no formal training in economics, the Nobel Prize in Economics in 2002. So in today’s Finshots, we thought we’d talk about what led to him winning the prestigious award.

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The Story

If you’ve ever taken an economics class, you’ll know the number one assumption embedded into most classic theories or models is that human beings are rational!

This assumption says that we will make sensible choices in our own self-interest. There’s even a term for this — “homo economicus”.

But Kahneman didn’t believe in this theory of rationality. He was a trained psychologist who knew that human beings are complex creatures with their own kinks. So when he came across an economics paper in 1970 that stated something so absurd, he knew he had to do something. He called up his friend Amos Tversky, a fellow psychologist in Israel, and they got to work to debunk some theories.

First things first, they addressed decision-making or rationality in a paper in 1971.

They said that human beings probably operated using two systems — one based on intuition and the other for reasoning.

Sidebar: Even though Kahneman’s book popularised this as System 1 and System 2, he credits it to a couple of other researchers Keith Stanovich and Richard West who originally came up with that labelling.

And the thing was that human beings liked to avoid cognitive efforts as much as possible. That we didn’t like mulling over things too much. That we preferred to use shortcuts or rules of thumb that would save time and mental bandwidth. So System 1 which relied on intuition often took over.

For instance, let me ask you a question.

“A bat and a ball cost ₹110 in total. The bat costs ₹100 more than the ball. How much does the ball cost?”

If your immediate answer was “₹10”, you’re wrong. But you chose that answer because ₹110 splits naturally into ₹100 and ₹10. So it seems right.

But if you’d thought about it for a few seconds, you’d have realized the ball is just ₹5. And since the bat is ₹100 more than the ball, the bat actually costs ₹105.

You let System 1 take over and didn’t slow down enough to let System 2 run through its deliberations. And most people end up in the same boat. We tend to trust a judgment that quickly comes to mind. And that could also lead to making wrong economic decisions that wouldn’t work in our favour.

It could have to do with a whole variety of things — it could depend on how a question is framed or even how recently information about something relevant has been made available to us.

But it all boils down the fact that rationality isn’t our strong suit.

So once they’d proven that human beings weren’t rational, the next question was how do people make decisions when there’s risk involved?

For instance, let’s say that I ask you to flip a coin. I tell you that depending on the outcome, you win ₹750, or you lose ₹500.

Would you take the risk?

Now back in the day, economic models followed something called the expected value theory. This says that since people are rational, they’ll calculate the probability of winning or losing. And since this is a coin flip, that’s a 50:50 shot. Then you’ll think that since you could potentially win more than you lose, it’s worth a try. So you’ll take the risk and flip it.

But in the 1700s, Swiss mathematician Daniel Bernoulli tutted his head and said this wasn’t true. And that even if the expected value suggested that you flip it, many people wouldn’t. And that’s because it all depends on the ‘utility’ that people ascribe to the wealth.

Basically, your decision to flip it will depend on how useful you think the wealth of ₹750 is going to be. Or how much you will benefit from it.

This was the expected utility theory. And for 300 years, this was the model most economists followed too. It was based on rationality too.

Until Kahneman and Tversky came along and said, “Hold on…we believe that’s incorrect. We think these sorts of decisions actually depend on an initial reference point. And it’s not just based on the final utility.”

So they explained this with an example (and you might have to read this bit twice).

Problem 1: You have ₹x in your bank account. But we give you an additional ₹1000. And then ask you to choose between these options — You have a 50% chance to win ₹1000 or get ₹500 for sure.

What would you choose?

You'll probably take the sure thing. Right?

Problem 2: You have ₹x in your bank account. But we give you an additional ₹2000. And then ask you to choose between these options. You have a 50% chance to win ₹1000 or lose ₹500 for sure.

In this case, you'll probably take the gamble.

But if you think about it clearly, in terms of the final state of wealth, both A and B are same. Both offer the certainty of being richer by ₹1500.

So as per the expected utility of wealth, you should've made the same choice in both cases.

But the reference point made a big difference in decision making. The reference point is higher than your current wealth by ₹1000 in Problem 1 and by ₹2000 in Problem 2.

And that means you end up thinking of the possible gain while evaluating Problem 1 and the possible loss while making a decision in Problem 2.

And it wasn’t just that.

Let’s take that initial coin flip example. When Kahneman and Tversky ran their experiments, they found that in a game of 50:50 probabilities, people would reject the game unless the possible win was at least twice the size of the possible loss.

And this led them to conclude that people were naturally risk-averse but the pain from a loss was also 2x the joy from a gain.

The results of this became the prospect theory in 1979 and changed the face of economics.

Anyway, there’s just one last thing. Just because he won the Nobel Prize in Economics, didn’t mean that Daniel Kahneman was never wrong.

The bestseller, “Thinking, Fast and Slow”? Well, that was riddled with errors. Okay, it wasn’t completely his fault but more the fault of the studies he’d relied on for the book.

For instance, Kahneman used a field of psychology called social priming in his book while trying to explain concepts.

For the uninitiated, social priming simply means that if you present a subtle cue or stimuli, it can influence people’s behaviour at a later stage. And one of the biggest ‘fake’ stories to explain this theory is when a theatre showed the words “eat popcorn” and “drink Coca-Cola” for a few seconds on screen, everyone rushed to buy them without really knowing why they suddenly had the craving and the sales shot up.

But later research showed that social priming was a load of baloney. Researchers couldn’t replicate the results. And it simply didn’t work.

So yeah, Kahneman got a few things wrong in his time.

But here’s what we should know. He never let his mistakes deter him. He accepted them. And in fact, he was actually pretty proud of the mistakes. He believes there was pleasure in finding out that he was wrong because it then meant he would learn something new.

That’s the LinkedIn-esque takeaway everyone needs, no?

Until then…RIP Daniel Kahneman.

PS: While Kahneman won the Nobel Prize in Economics in 2002, Tversky died in 1996 and since Nobel Prizes are not awarded posthumously, he didn’t get a chance to share the honour.

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