Nobel Winner Daniel Kahneman's New Book on Bad Decisions Has a Lot to Say About Market Overconfidence and Money Mistakes

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Nobel Prize-winning psychologist and economist Daniel Kahneman has a new book out asking a question that is central to making the right calls on the markets and money: Why does everyone make such bad decisions and what can we do about it?

"Noise" was co-written with Olivier Sibony, a French expert in decision making, and Cass R. Sunstein, a legal scholar and behavioral economics expert. Kahneman is one of the founding fathers of behavioral science and author of the seminal work, "Thinking Fast and Slow."

My review of the book is here:   

I sat down with Dr. Brad Klontz, a member of the CNBC Financial Wellness Council to get his reaction to Kahneman's central thesis, which is that biases and noise (random variability in our judgments) are ever-present in our lives, but there are ways we can improve our judgment skills. Dr. Klontz is a CFP and psychologist and author of several books, including most recently, "Money Mammoth" (Wiley, 2020).

CNBC: The central thesis of the book is that people — particularly professionals like doctors, judges, and financial advisors — often make very bad judgments. Radiologists don't provide consistent interpretations of X-rays. Judges don't provide consistent judgments. Financial advisors are overconfident in their advice. Do you concur?

Klontz: Yes.  Being an expert in a particular field can make biases more difficult to identify, more resistant to change, and lead to greater harm.

CNBC: Kahneman says there are problems with "bias," where people are consistently weighted toward one viewpoint, like a bathroom scale that is always two pounds over. But his emphasis is on "noise" which he calls "random variability in judgments," where the decision-making is random and inconsistent.  Why does that happen?

Klontz: Partly it's a problem that people don't recognize the random nature of their decision making. But there's other reasons. While it can backfire, ironically, variability in judgment has been one of the keys to our survival as a species. Many decisions are not black and white. In primitive times and today, people could die from a bad judgment, so there is a bit of natural selection in there.

This problem is well-known in the field of psychology. For example, random error exists in all attempts to measure things, such as personality traits or the effectiveness of medications or therapies. We use the scientific method and statistical analysis to try to mitigate random error, but it is always a threat to our trying to make sense of objective truth. 

CNBC: Kahneman recommends several ways to combat bad decision making and noise. He talks about "decision hygiene" or ways of making more consistent judgments. Does that make sense?

Klontz: Yes. I love the concept of delaying intuition, of not immediately acting on your instincts. Open-mindedness is associated with success in almost all endeavors. Don't trust your instincts. In my last book "Money Mammoth" I talked a lot about the "tribal brain," what is the optimal way to deal with life in a group of about 150 people, which is how our ancestors lived. It helps explain why we should mistrust our instincts when it comes to money, because the exact same instincts that helped us survive and thrive in small groups with constant threat often backfire in our modern financial lives. In essence, when it comes to money we are wired to do it all wrong. 

For example, herd instinct is good when you are in a primitive society.  If everyone is running from a lion, you should too. If you decide to not go along with the herd and are standing still, you are going to get eaten. Everyone who believed you should stand still while everyone else is running has gotten picked off, and they didn't pass down their genes to us. 

While it helped us survive throughout all of prehistory, the herd instinct is bad when you are making modern financial decisions. When everyone is getting into cryptocurrency, we are hard-wired to believe that we should join them. On a deep psychological level, it feels like a threat to our survival to not jump in. So we have to keep second guessing and combatting our natural instincts. Always second guess yourself, avoid overconfidence, and stay open-minded.

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CNBC: So we should have less confidence in our instincts?

Klontz: We would transform our world if we had less confidence in our conclusions. We are constantly segregating ourselves and surrounding ourselves with people who think like we do. Sometimes our beliefs are so strong we try to hurt people who believe differently. We need to be able to observe ourselves more objectively. 

Less confidence would reduce conflict because we're not as entrenched in our subjective conclusions.

Putting some time between our impulses and actions helps calm down our emotional brain and helps us activate our prefrontal cortex — the part of our brain that helps us think through the consequences of our actions. It can also give us time to seek out the opinions of others too. 

CNBC: Kahneman also recommends that organizations do "noise audits" where they check to see how consistent the judgment-making is among their group, whether it is radiologists, judges, or stock pickers. Your reaction?

Klontz: It's a great idea, and the only surprising thing is it's not done on a regular basis. This is well-known in psychology. It's called inter-rater reliability, which acknowledges that it can be difficult for even experts to agree on their analysis and conclusions. For example, in diagnosing an autism spectrum disorder, the gold standard focuses on training to ensure inter-rating reliability to make sure everyone is coming to the same conclusion. And I absolutely agree it should be done elsewhere. We should put much more work into taking established methodology in psychology and generalizing it across professions, especially those that are involve life and death decisions, like medicine or law. 

CNBC: Kahneman recommends more rigorous use of rules-based decision making to get away from random human judgments. Do you agree?

Klontz: Yes, particularly when there is a clear indication of a correct or incorrect decision, such as this person has a tumor or they don't. When there are clear life or death decisions, we need to limit variability in judgment. I mentioned the autism diagnosis. That is where you need a structured, reliable, rules-based approach. 

But we can't become too rigid or rule-bound and need to keep an open mind. We have to recognize that there will be changes in the rules as our knowledge base increases and be open to changing those rules when the facts change.

Also, remember many decisions and conclusions in life are entirely subjective. The idea is not so much to stamp out variability in human judgment, but to come to terms with its existence and with the idea we are vulnerable to misjudgments. Awareness and humility is the key. Recognizing that we can make a different judgment depending on what time of day it is, or what we had for lunch, is a key step toward making better judgments.

CNBC: One of my favorite chapters was where Kahneman noted that people, particularly professionals, have very high opinions of their own opinions.

Klontz: Yes, there's an evolutionary benefit to that. Say you're convinced a famine is coming and the other guy is convinced there is no famine coming.  If you get a famine, you are fine because you planned for it, but the other guy is gone. So believing in your own opinion, and convincing other people to go along with you, has helped us survive as a species.

But in the modern world it can lead to overconfidence. For example, women tend to outperform men as investors. They are not as vulnerable to overconfidence. Men believe they can outperform and end up by trading more. The evidence is they can't. Again, a healthy dose of self-doubt can be very good for us.

CNBC: Kahneman also devotes some time to discussing why everyone is so bad at predicting the future. 

Klontz: We all know you can't predict the future for exactly the reasons Kahneman said: We are saddled with biases and noise, and there is an unknowability about the future because things happen that are not predictable. 

But this doesn't prevent us from trying, and it's important to understand why. Again, this desire to predict the future is an evolutionary advantage. It's necessary to try to predict the future because it has helped us survive as a species. It's essential to our survival. The ones who are future-oriented and worry about the future are the ones who may have survived in the past.

But that doesn't help us as much in the modern age. We have not evolved much from "Lighting means the gods are angry." Most of our decisions are made by our emotional brain, and we have a relatively small prefrontal cortex that does the rational thinking on top of a large emotional brain — and when we get excited or scared our emotional brain kicks in and we are vulnerable to acting like our prehistoric ancestors.

So we can't eliminate attempts to predict the future, because we are thinking about it all the time.  However, it is essential that we don't put too much weight into our predictions, and to recognize that they are merely our attempts to make sense of a chaotic world. It is important for us to recognize the limitations of our knowledge and become a little more comfortable with uncertainty.  

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