Daniel Kahneman, a Nobel Laureate in economics, whose pioneering behavioral science research changed our understanding of how people think and make decisions, died at the age of 90 on March 27.
Daniel Kahneman—Eugene Higgins Professor of Psychology
Emeritus at Princeton University and Professor of Psychology and Public Affairs
Emeritus at Princeton’s Woodrow Wilson School of Public and International
Affairs—collaborating with his colleague and friend of nearly 30 years, late
Amos Tversky, applied cognitive psychology to economic analysis and thereby
built a “bridge between the economic and psychological analyses of individual
decision making” under uncertainty paving the way for “the new and rapidly
expanding field of behavioral economics”.
Traditionally, economists assumed that each person makes rational choices in pursuit of his/her self-interest. Based on this assumption, they came up with ‘rational choice theory’ which states that individuals use rational calculations to make choices and achieve outcomes that are in alignment with their personal objectives. Accordingly, they built elaborate theoretical and mathematical models to explain how markets work to efficiently allocate capital and set prices.
As against this well-established theory, Daniel Kahneman and Amos Tversky demonstrated in the ’70s and early ’80s that often individuals make illogical choices that sabotage their economic interests, that too, believing that they are rational. They argued that humans faced with uncertain situations tend to make judgments and make decisions based on systematic biases. According to them, people, the economic agents, rely as much on flimsy grounds as on solid evidence of the likely outcomes. They are said to be guided less by probabilities and more by how closely a situation represents their preconceived ideas. They care more about changes rather than absolute levels of change and care more about losses than they do about equal-sized gains. They even have a propensity to stick with the status quo.
Incorporating several such patterns, they came up with the “Prospect Theory” in a paper published in Econometrica in 1979 explaining mathematically how people make choices in the face of risk and uncertainty. According to it, individuals “underweight outcomes that are merely probable in comparison with outcomes that are obtained with certainty”. This tendency called the ‘certainty effect’ leads to risk aversion in choices involving sure gains and to risk-seeking in choices involving sure losses. It also states that people generally discard components that are shared by all prospects under consideration and instead focus on the components that distinguish them. This kind of behavior, called ‘isolation effect’, is likely to result in inconsistent preferences when the same choice is presented in different forms. They have also proposed an alternative theory of choice in which utility is based on changes in wealth rather than the absolute states of wealth and in the process individuals replace probabilities by decision weights.
There is another important element of the prospect theory: the key concept of ‘reference point’, which is nothing but the starting point from which individuals make decisions about gains and losses. It can be either an actual or an imaginary starting point. Kahneman and Tversky state that the reference point is determined by several factors such as: past experiences, current circumstances, cultural norms, individual preferences, etc. According to them, a reference point is not always static.
The prospect theory model looks like an S-curve, which is normally concave for gains in the first quadrant and convex in the third quadrant representing loss. The slope of the loss function is generally steeper than that of the gain function, for people are known to assign a higher value per unit of loss than they do for the unit of gain. It otherwise means that people are more upset about losing something than they are happy about gaining the identical amount. This asymmetry explains the ‘loss aversion’ of people. The prospect theory thus challenges the very basic tenets of utility theory that was fundamental to economics.
The prospect theory also suggests that people make decisions in two stages: an early phase of editing stage in which individuals simplify complex situations by ignoring some information and by using mental shortcuts (heuristics) and at the later evaluation stage edited prospects are evaluated and the prospect of highest value is chosen. According to the prospect theory, people will be more risk-averse when the stakes are high and more risk-seeking when the stakes are low.
Kahneman popularized their research relating to the prospect theory through his book, Thinking Fast and Slow, which was published in 2011. In it, he demonstrated to what extent our ability to make decisions is influenced by subconscious quirks and mental shortcuts that can ultimately distort our thoughts, of course, in predictable but irrational ways. He further explored how the brain processes information and makes decisions using two systems: System 1, which is the domain of intuitive responses that is riddled with human biases; and System 2 which is slower, analytical and deliberate where we consciously collect evidence, sift through facts, evaluate them and then take a decision.
Daniel Kahneman’s Thinking Fast and Slow, which appeared on best-seller lists in science and business that made him popular in the public domain, was placed in the same league as Adam Smith’s The Wealth of Nations and Sigmund Freud’s The Interpretation of Dreams by Nassim Nicholas, the mathematical statistician and former option trader and author of The Black Swan.
The prospect theory of Kahneman and Tversky later caught the attention of mainstream economists who incorporated their insights into economic modeling. Indeed, psychological biases were documented and used to explain various economic topics such as consumer behavior, labor markets, financial markets, etc., in the ensuing decades. Notable among them is Richard Thaler who won the Nobel Prize for his work in the field of behavioral economics. As Kahneman and Tversky have categorically stated in their paper in Econometrica, prospect theory, though explicitly concerned about monetary outcomes, can as well be used to assess choices that involve other attributes such as quality of life, or the impact of policy decisions, etc.
After working on biases and how they lead to errors in judgment for almost 50 years of his career, Kahneman, having encountered another type of error called ‘Noise’, worked on it and coauthored the book, Noise: A Flaw in Human Judgment along with Olivier Sibony and Cass R Sunstein (Hachette Book Group, May 2021). The concept of noise and its adverse impact on judgments is, of course, not as familiar as the impact of psychological biases on judgments. Defining noise as the “unwanted variability in professional judgments”, authors stress that the word, ‘unwanted’ in the definition is more important. For, variability in certain judgments may not be a problem while in certain cases it is even desirable—of course, but certainly not in professional judgments. For instance, if two doctors give two different diagnoses, at least one of them must be wrong. That is where variability in judgment is not permissible. Differentiating noise from bias, Kahneman once said: “Put simply, bias is the average error in judgments ...errors in those judgments all follow in the same direction, i.e., bias. By contrast, noise is the variability of error...errors in those judgments follow in many directions, that is noise”.
Noise is found within the system in which judgments are made. In one of his lectures, Kahneman said, “Whenever there is judgment there is noise and probably more than you think”. To quote him, the most striking example of noise distorting judgments is: Performance reviews. His research had shown that only one quarter of rating rests on actual performance while the rest three quarters is related to noise. It can be: “level noise”—some raters are on average more generous than others; “Occasion noise”—the rater may be in a better disposition today than on other days; or, it could be idiosyncratic response of a rater to a ratee. Thus when all these things are put together, three quarters of a performance rating is turned out to be based on pure noise. Citing the example of underwriting in insurance sector, he said that it is understandable that there would be divergence in the premium quoted for the same policy by each underwriter, but the question is: “How much divergence?” He said that when the average was computed from the study undertaken it stood at a startling 56%. Now what is more alarming is the question Kahneman raised: “How can it be that people have that amount of noise in judgment and not be aware of it?”
Noise can also be there within an individual. For instance, when a problem is presented twice to the same person, we notice that he/she, not realizing that it is the same problem, gives different answers. Driven by their research, the authors assert that wherever there is judgment, there is noise and probably more of it than one thinks. Hence, Kahneman suggests for a “noise audit” followed by practicing “decision hygiene” as a means to reduce noise in the organizations. Their book indeed suggests a set of specific procedures for reducing the noise. One of the important suggestion that Kahneman made for better judgments to happen is: “Don’t trust people, trust algorithms”. For, algorithms are rule-based. He further said, “Train people in a way of thinking and in a way of approaching problems that will impose uniformity”.
Kahneman never took an economics course. But his path-breaking research along with his friend Tversky which revealed how hard-wired the human brains are with mental biases that warp judgments of people, had simply transformed the fields of economics and investment theories. This lifelong research of Kahneman had fetched him Nobel Prize in economic science in 2021. To quote Harvard psychologist and author, Steven Pinker, his work would remain “monumental in the history of thought”. In an interview in 2021, this mighty thinker wondered how “linear people” would adjust to the quickly advancing, nay exponentially advancing artificial intelligence. That was his insatiable interest in how others think!
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