Nobel Prize-Winning Psychologist Daniel Kahneman (RIP) Explains the Key Question Every Investor Must Ask, and Why It’s a Fool’s Errand to Pick Stocks

This past week, the influ­en­tial psy­chol­o­gist and econ­o­mist Daniel Kah­ne­man passed away at age 90. The win­ner of the 2002 Nobel Prize in Eco­nom­ic Sci­ences, Kah­ne­man wrote the best­selling book Think­ing, Fast and Slow where he explained the two sys­tems of think­ing that shape human deci­sions. These include “Sys­tem 1,” which relies on fast, auto­mat­ic and uncon­scious think­ing, and then “Sys­tem 2,” which requires atten­tion and con­cen­tra­tion and works more slow­ly. And it’s the inter­play of these two sys­tems that pro­found­ly shapes the qual­i­ty of our deci­sions in dif­fer­ent parts of our lives, includ­ing invest­ing.

In the inter­view above, Steve Forbes asks why indi­vid­ual investors per­sist in believ­ing that they can pick stocks suc­cess­ful­ly over time, despite ample evi­dence to the con­trary. Draw­ing on his research, Kah­ne­man describes the “illu­sion of skill,” where investors “get the imme­di­ate feel­ing that [they] under­stand some­thing,” which is much “more com­pelling than the knowl­edge of sta­tis­tics that tells you that you don’t know any­thing.” Here, Sys­tem 1 cre­ates the “illu­sion of skill,” and it over­whelms the slow­er ana­lyt­i­cal think­ing found in Sys­tem 2—the Sys­tem that could use data to deter­mine that stock pick­ing is a fool’s errand. When Forbes asks if investors should ulti­mate­ly opt for index funds instead of indi­vid­ual stocks, Kah­ne­man replies “I am a believ­er in index funds,” that is, unless you have very rare infor­ma­tion that allows you to pick stocks suc­cess­ful­ly.

Lat­er in the inter­view, Kah­ne­man touch­es on anoth­er impor­tant sub­ject. In his mind, the first ques­tion every investor should ask is not how much mon­ey should I plan to make, but rather, “How much can I afford to lose.” Every investor should assess their risk tol­er­ance, in part so that you can han­dle tur­bu­lence in the mar­ket and stick with your ini­tial invest­ment plan. If you are not aware of your risk tol­er­ance, “when things go bad, you will want to change what you are doing, and that’s the dis­as­ter in invest­ing… Loss aver­sion can kill you.” He con­tin­ues, “Emo­tions are indeed your ene­my. The worst thing that could hap­pen to you …  is to make a deci­sion and not stick with it, so that you bail out when things go bad­ly, so that you sell low and buy high. That is not a recipe for doing well in the stock mar­ket, or any­where.” Ide­al­ly, you should fig­ure out upfront how much you want to put in the stock mar­ket, and how much you want to keep out, so that you can psy­cho­log­i­cal­ly man­age the ups and downs of invest­ing.

From here, Kah­ne­man comes to his most impor­tant piece of advice for investors: Know your­self in terms of what you could regret. If you are prone to regret, if invest­ing makes you feel inse­cure and lose sleep at night, then you should adopt a “regret min­i­miza­tion strat­e­gy” and cre­ate a more con­ser­v­a­tive port­fo­lio to match it. Read more about that here. Also see Chap­ters 31 (Risk Poli­cies) and 32 (Keep Score) in Think­ing, Fast and Slow where Kah­ne­man talks more about invest­ing.

This post orig­i­nal­ly appeared on our sis­ter/­side-project site, Open Per­son­al Finance.

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