Timeless Investment Lessons from a Great Thinker
“All of us would be better investors if we just made fewer decisions.”
Those were words frequently spoken by Daniel Kahneman, a Nobel prize-winning psychologist who passed away last week. Kahneman won the Nobel Prize in economic science in 2002. But interestingly enough, he never once took an economics course. Instead, Kahneman was focused on behavior—how humans’ hard-wired mental biases cause us to make poor decisions and/or behave irrationally.1
If there’s truth to the statement that ‘investors are their own worst enemies,’ which I personally believe to be the case, Kahneman spent most of his career trying to figure out why.
All of the discoveries he made along the way created an entirely new field within economics, called behavioral economics. Kahneman upended the theory that people act rationally, in their own self-interest, and with consistent preferences when making decisions. In fact, his research found that investors often do just the opposite.
Kahneman recognized that investors often make—and repeat—the same mistakes over time. For instance:
• Why do investors seem to sell winners too early and hold onto losing positions too long?
• Why do we think a few smart trades all of a sudden deems us an immutable expert (instead of just lucky)?
• Why are many investors compelled to make decisions with low probability of success, like betting big on a “hot stock”?
• And, perhaps most critically, why do we feel differently about losses than we do gains?
The last point was developed into a theory that helps explain loss aversion. Here’s a hypothetical example of how it works. Investor A has a $1,000,000 portfolio that grows by 30% in a single year, and in a straight line, ending at $1,300,000. Investor B has a $1,000,000 that books a 50% gain in the first 11 months but then falls 20% in December, also ending the year at $1,300,000.
Given that both Investor A and Investor B end up in the same place, it objectively should not matter which investor you’d rather be. But almost all investors would prefer to be Investor A, since that portfolio did not experience any losses along the way. Put another way, if you were to ask a big group if they’d be willing to take a risk with an 80% chance of success, most would say yes. But if you ask the same group about their willingness to take the same exact risk but with a 20% chance of failure, many would pass.
It’s this aversion to losses that can easily lead to poor judgment over time. Because investors loathe losses about twice as much as they appreciate gains, they tend to try and guard against those losses—often in the wrong ways and at the wrong times.
Looking at the chart of the S&P 500 below from mid-2019 to present day, we can see that the S&P 500 has booked an approximately +75% gain. But it’s also true that there was a sharp and scary bear market in 2020 with the pandemic, and a drawn-out bear market in 2022 when inflation soared. Loss aversion may have caused some investors to get out of the market during these years, when ‘making fewer decisions’ would have arguably resulted in a better outcome.
Bottom Line for Investors
Kahneman’s work illuminated loss aversion and many other biases, all of which make investors act irrationally, against their own interests, and with ever-shifting strategies and goals—the opposite of how investors should behave.
Recognizing and understanding these biases gives investors the tools needed to keep a steady hand and make decisions rationally, and thoughtfully. If sharp downside volatility in the market has you thinking you need to sell stocks and get out, remember that your mind is essentially hardwired to exaggerate this negative impact. If you change your asset allocation as a result, running counter to your long-term goals, there’s an argument that you’re actually adding risk to your portfolio, not taking it away. This is irrational behavior.
Investors tend to characterize short-term occurrences—like a rapid run-up in a stock’s price—as sufficient data for predicting what will happen next. That’s why “chasing heat” is such a widely-known term. This leads to all sorts of bad traits for investors—overconfidence, thin research, subjectivity, and many, many others.
Kahneman suggested that the key question to ask before making an investment decision is, what is the base rate? This means prefacing every important decision by establishing the objective odds of success, based largely on history. In equity market terms, and in its simplest form, investors might ask themselves how often the stock market delivers attractive returns in 10-, 20-, or 30-year periods. The answer, of course, is nearly 100% of the time.
Disclosure
2 Fred Economic Data. April 2, 2024. https://fred.stlouisfed.org/series/SP500#
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