On the Legacy of Danny Kahneman

Daniel Kahneman and Amos Tversky wrote a paper published in 1974 called “Judgment Under Uncertainty”. In 1976, Richard Thaler had just earned his PhD at the University of Rochester, was beginning to teach there, and was going to spend the summer at Stanford working with Sherman Rosen.  

Thaler had been so impacted by that paper, and other work by Kahneman and Tversky, that he was more than excited to learn that Danny and Amos would also be in Stanford, spending the academic year there.

Perhaps naturally, Thaler struck up a relationship with the both of them. At the time, Danny and Amos were working on a paper about prospect theory (which they originally called “value theory”). Thaler ended up spending the entire year at Stanford, collaborating with both of them, and started to put the pieces together, incorporating things he knew about economics and finance with things that Kahneman and Tversky knew about psychology.

Then, that prospect theory paper came out in 1979, and this one really got things rolling. 

As an economist, Thaler had noticed years earlier several areas where the market seemed not to be acting rationally. With all this work by psychologists Kahneman and Tversky, Thaler started wondering if perhaps Danny and Amos had some of the answers.

Thus, the field of behavioral economics was born.

A few years later, in 1984, Thaler and Kahneman took sabbatical at the same time, and Thaler joined Danny out in Vancouver (Tversky, also on sabbatical,went to Israel). From that point the entire field really started to take off.

As Thaler writes in Misbehaving, arguably the first “behavioral vs. rational” conference happened the following year (1985) at the University of Chicago. In the behavioral corner were Danny, Amos, Herb Simon and Kenneth Arrow, with younger “discussants” Richard Thaler and Bob Shiller. While on the rational side were none other than esteemed academic finance giants Merton Miller, Eugene Fama, Robert Lucas, and Sherwin Rosen.

The debate, of course, has been raging ever since, and ten years later the University of Chicago asked Thaler to join their faculty, and have that debate every day – and he has for nearly 30 years.

And all of this started because an economist was so inspired by an academic paper by a couple of psychologists. And in 2002, one of those psychologists, Danny Kahneman, won the Nobel Prize...

...in Economics.

Fast forward to 2003, and Michael Lewis wrote the extremely well-written (and popular) book Moneyball. He got lot of reviews (not great ones from old-school baseball fans, but mostly positive). One of the critiques was by Richard Thaler (and his collaborator Cass Sunstein), which Lewis called “both generous and damning.”  

In the piece, Thaler and Sunstein wrote, “the author of Moneyball did not seem to realize the deeper reason for the inefficiencies in the market for baseball players. They sprang directly from the inner workings of the human mind – working which had been described years ago by a pair of Israeli psychologists, Daniel Kahneman and Amos Tversky.”

In Michael’s words, “(My book) was simply an illustration of ideas that had been floating around for decades and had yet to be fully appreciated by, among others, me.” And this of course intrigued the living daylights out of Michael Lewis.

As luck would have it, Lewis lived (literally) down the street from Kahneman, and then he too struck up a relationship, and the result was “The Undoing Project; A Friendship that Changed the World.”

And it did.

Fast forward again here to 2024, and we’ve lost him, but his legacy will carry on more than he ever might have imagined.

For stock-pickers such as ourselves, we must be conscious of the fact that Danny didn’t think very highly of our industry. Here he is in “Thinking Fast and Slow”:

‍“…my questions about the stock market have hardened into a larger puzzle: a major industry appears to be built largely on an illusion of skill. Billions of shares are traded every day,with many people buying each stock and others selling it to them. Most of the buyers and sellers know that they have the same information, and they exchange stock primarily because they have different opinions. What makes them believe they know more about what the price should be than the market does? For most of them, that belief is an illusion.”

He then describes that it is psychology that drives the illusion. He describes that we all are part of a “powerful professional culture” that can “maintain an unshakeable faith” in any proposition, “however absurd”, because that faith in skill over luck is “sustained by a community of like-minded believers.” He continues with the primary driver of this faith:

 “The most potent psychological cause of the illusion is certainly that the people who pick stocks are exercising high-level skills. They consult economic data and forecasts, they examine income statements and balance sheet, they evaluate the quality of top management, and they assess the competition. All this is serious work that requires extensive training…but unfortunately, skill in evaluating the business prospects of a firm is not sufficient for successful stock trading, where the key question is whether the information about the firm is already incorporated in the price of its stock.”

But what if the stock price is incorporating the wrong information? Perhaps Kahneman is leaving a small crack in the window for all of us stock-pickers out there. It was Kahneman & Tversky (1979) themselves that showed us how we all become risk seeking when facing losses and risk averse when facing gains. This observation in fact became a theoretical underpinning behind the intermediate-term momentum phenomenon. The authors essentially were telling us that human beings (and perhaps Mr. Market himself) can incorporate the wrong public information.

So maybe ignoring the wrong information and focusing on unbiased analysis of the right information is the only way to be skillful in stock trading?

‍And maybe, spotting this overemphasis on wrong information (good or bad) – as predicted by behavioral finance – is the very skill required to “beat” Mr. Market.

Importantly, Danny Kahneman himself, the one who identified many of the behavioral biases affecting us in the first place, states that awareness of the bias doesn’t prevent even him from making the same behavioral mistakes that humans are apt to make.

In other words, Danny might say we have our work cut out for us, but at least he has laid down the foundation for the problem we are trying to solve.

In order for us to succeed – and by succeeding I mean generating alpha – we will need to have an investment regime which a) recognizes the difficulties of correcting our own biases, and b) fosters a culture to ensure as much objectivity as possible.[1]

Those that don’t will only succeed if they are lucky.

Or cheat.  And we don’t cheat.[2]