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Cutting Through the Noise

Daniel Kahneman on applying behavioral psychology to financial advice.

The 30th annual Morningstar Investment Conference in June was a fitting platform for a conversation with Daniel Kahneman, one of the founding fathers of behavioral economics and a recipient of the Nobel Memorial Prize in Economic Sciences in 2002. In partnership with Amos Tversky[1] and others, Kahneman’s research on judgment and decision-making established that heuristics and biases can lead to errors—a refutation of the perfectly rational investor. In “Prospect Theory: An Analysis of Decision Under Risk,”[2] Kahneman and Tversky provided more realistic models of economic behavior and gave us the vocabulary of frames and anchors common in behavioral finance today.

Interviewing Kahneman was a professional and personal pleasure. His work underpins our behavioral science efforts at Morningstar. As a behavioral economist who focuses on the psychology of financial decisions, I would not have been able to pursue my career path had not Kahneman and his contemporaries paved the way. Our conversation has been edited for length and clarity.

Sarah Newcomb: When you look back at what you’ve accomplished, what do you feel most proud of?

Daniel Kahneman: Thinking, Fast and Slow[3] came out when I was 77 years old. I was very proud of having been able to pull something off at that age.

Newcomb: You’ve talked about the Lifetime Achievement Award for the American Psychological Association being something that’s close to your heart.

Kahneman: Of the awards I’ve gotten, I think that’s the one. It was from my colleagues, and it was for the whole of my work, and I was very honored by that.

Newcomb: For those of us already feeling a bit dwarfed by your accomplishments: He has a Nobel, and it’s not what he’s most proud of!

I would argue that the greatest contribution psychology has made to the financial industry has been to make the subjective measurable. Economists treat people as rational to make the models work. It’s a simplification; nobody really believes that. It’s just that measuring all the human differences seemed like an intractable problem. But then psychologists like you came along. It wasn’t the first time. Back in the 1730s, Bernoulli did it. In the early 1900s, Herbert Simon did it. But it never really caught on. And then you and your colleagues come along, and the ideas just exploded. What was it about the work or the time that made people ready?

Kahneman: I think it’s because we adopted a method of presenting our data where we put questions inside the text and turned the readers into their own subjects. We asked very simple questions that they answered wrongly. That’s the trick. We chose the questions because we were inclined to answer them wrongly; they illustrated intuitive mistakes and intuitive errors. Our readers participated in their own experiment and discovered that it’s not about subjects and psychological experiments. It’s something that they themselves are prone to. People could recognize themselves in our work.

Newcomb: Did you have any pushback from economists in academia?

Kahneman: Initially, they just ignored us completely, so I wouldn’t call that pushback. A few of them were quite dismissive and contemptuous, but it didn’t bother us much. A few economists gambled their career on it; one of them is Richard Thaler, who got a Nobel prize just last December. Those economists did encounter pushback.

We wrote primarily for psychologists, and the impact there was fairly rapid. Then, we wrote a major paper on decision-making, how people make choices under uncertainty, and we published that in the prestigious economics journal Econometrica. That’s not because we wanted to influence economics. It just happens to be the case that the best decision-making papers get published in that journal. But it was enormously important because economists tend to be quite parochial in what they allow into their consciousness and in what they take seriously. I think that ultimately is what made the Nobel possible.

Profit Motive
I’m grateful that the private sector values interdisciplinary work. But being a behavioral economist in the private sector, I often feel like people are interested in this science for all the wrong reasons. “People are predictably irrational; how do I profit from it?” What are your thoughts on how “nudge science” and psychology are being used in the private sector?

Kahneman: There are certain classes of people who are interested in exploiting human foibles for profit, but that’s not the majority. You’ll find hedge funds—and this is a perfectly reasonable thing to do—that bet against human psychology, and some of them are doing very well. Most people in this audience, if they’re interested in behavioral economics at all, it is to help people. In order to be able to help people make good decisions, you’ve got to understand the barriers that prevent them from doing so on their own. That is a niche for behavioral economics.

Newcomb: Should private-sector behavioral economists develop guidelines to ensure we’re preserving and respecting people’s autonomy and not manipulating them?

Kahneman: The first step, of course, would be fiduciary standards. The next question is, what defines the client’s interest? That turns out not to be an easy question at all. The client’s interest in terms of what they want to do now is one thing. If it’s in terms of their financial health in the distant future, you may need to find some way of leading people. “Leading” may be too strong a word but show them a way to live a financial life so that when something bad happens they don’t immediately want to change direction, which I think is the biggest danger for financial health. There are many things that can be done by applying behavioral economics to those questions and applying the psychology of risk-taking, the psychology of risk avoidance, of how people view the future.

Newcomb: In the wake of Cambridge Analytica and Facebook FB, it’s relevant for us to examine the way that we are studying people and using the data that we collect. You have experience in this area in your consulting work.

Kahneman: That was an unpleasant episode. The consulting firm I was working with was hired by a financial institution that has advisors associated with it, and they wanted these financial advisors to do better financially. I participated in interviews with financial advisors, and we saw the whole gamut. There were people who clearly viewed their role in a way that I think is sensible, as in part a therapy role, guiding clients to sensible decisions. They were there as advisors when their clients wanted to send a kid to college or to buy a car or to divorce.

But I remember one person in particular who was completely cynical about what he was doing. He was actually charging 3% a year—a number that I found quite impressive—to manage money on the theory that the more he charged, the more people would think that he was worth it. He also tested people for a day and a half, which clients found very impressive. But I thought the testing was worthless, I thought he had nothing to offer for 3%, and I was appalled that that kind of thing was possible. I really did not want him to get richer. I eased my way out of that particular project.

Nudging the Nudgers
Nudges are extremely popular in design and advertising and marketing, and I don’t have a problem with that on its face. But as set forth by Cass Sunstein and Thaler in Nudge,[4] there is a paternalistic element. Who gets to be the arbiter of what’s in someone’s best interest? Who’s nudging the nudgers?

Kahneman: That’s a very difficult question, but there are a few guidelines that I think most people would find reasonable. My primary guideline for what I call rational behavior is something that I call broad framing. It takes a lot of considerations into account, so you want a balance between looking at the future and looking at the present. You want to balance how wealthy you might be 10 years from now and the emotions of fear and anxiety and so on that you might have to go through while you are getting there.

Not everybody is going to get the same advice. There was a period where I was working in financial advising for very wealthy people. We had the idea to develop what we call a regretproof policy. That is, it’s the kind of policy that somebody is likely to be able to live with. Even when things go badly, they’re not going to rush to change their mind or to change advisors and to start over.

We explained to people that this was not profit maximizing. Regret minimization and profit maximization are actually different. We told them that the optimal allocation for somebody who is prone to regret and the optimal allocation for somebody who is not prone to regret are really not the same. Everything is open, but in that conversation, you bring to bear things that people may not have been thinking about, including the possibility of regret, including the possibility of their wanting to change their mind, which is a bad idea, generally, because then you sell low and you buy high. There is a balance, and I think that balance can be found.

Newcomb: So, you use loss aversion to create this measure of projected regret?

Kahneman: We had people try to imagine various scenarios, and the question was, at what point do you think that you would want to bail out? There are some differences, but it turns out that even very wealthy people are extremely loss-averse. There is a limit to how much money they are willing to put seriously at risk.

We ended up with a solution where people actually have two portfolios. One is a risky portfolio and one is a much safer portfolio. They decide on the allocation between them. The portfolios are managed separately, and people get results on the two of them separately. That was a way that we thought we could help people be comfortable with the amount of risk that they were taking.

Newcomb: That puts a wall in between the money you can protect, that’s going to keep you safe, and the money that you’ll play with. It’s all the same portfolio, really, but there’s a psychological distance between the two.

Kahneman: This is an issue of framing. By having what you are willing to put at risk in one portfolio and what you are trying to protect in another, this corresponds to the way that people want to think about their decision-making and about their outcomes. One of the portfolios will always be doing better than the market, either the safe one or the risky one, and that gives people some sense of accomplishment. But mainly, it’s this idea of reducing the risk to a level that people are comfortable with. That turns out not to be a lot, even for very wealthy people. When you ask them how much of their fortune they are willing to lose, quite frequently you get something on the order of 10%, which is certainly not the optimal value.

Newcomb: What I see in the financial advice industry is sort of an existential crisis, an identity crisis. With advances in technology and products that enable people to, with the click of a button, craft an investment portfolio, a lot of advisors are asking, how do I create value for my clients? We talk at Morningstar about the value of behavioral coaching. Similarly, what you’re talking about sounds like something that a robot, by its very nature, can’t do.

Kahneman: People are recognizing that individuals tend to do very poorly in guessing what the market will do and in guessing how individual stocks will do. People who have a great deal of confidence in their ability to do that remember past successes, when they made a prediction and it worked. But by and large, admitting that you don’t know is a very healthy step. I think it’s good for advisors to not claim to know more than, in fact, they do.

But that still leaves them with a great deal to do. It leaves them with the task of discussing the client’s real needs and capabilities in terms of taking risk, and what their prospects for the future are, what their dreams are. Then, there is a handholding function, which is very important.

When bad things happen, you have to be there to try to keep people on an even keel. During times of crises, people need to have somebody they trust, who has their interests at heart and knows what they want, and who understands the field.

Newcomb: In many ways, what you’re talking about is something that advisors simply don’t get trained in. I hear from advisors that they’re basically psychologists but without the license. The asset allocation is the really simple part. It’s the human part that’s hard. We’re trying to create some tools for advisors to be able to have what they need in order to feel competent to have these conversations and not feel like they’re crossing a line that they shouldn’t be crossing into the realm of psychology.

Kahneman: You’re right, people who go into this profession have not had that training. If there is beginning to be general agreement that this is the core function of an advisor, then there is a need for continuing education. Roleplaying various situations and different kinds of conversations could be very useful.

Newcomb: Do you think that formal psychological training should be involved?

Kahneman: Not on the part of the advisors. You must provide education in a way that is compatible with advisors’ professional role. But that’s not impossible. I think you have to promote the idea that there is a need for it among advisors. My guess is that organizations like Morningstar are very well positioned, both to create the demand and to create the supply. It’s just a matter of decision.

Newcomb: We’ve been investing very heavily in efforts to do that. People want guidance on how to deal with various situations, and sometimes the answer is nuanced. We have to create models, so that people don’t feel like they’re flying blind. There’s human connection, there’s empathy, but there needs to be some kind of mathematical guide, too.

Kahneman: Most people have something they use to measure risk attitudes, but many of these tools are really quite inferior. I think that regret attitudes are very important to measure. I think attitudes about potential disasters are important to measure. The conversation between the advisor and the client is an educational opportunity. Part of it is for the advisor to educate the client about what might happen and to bring it to life, so that the client can make an informed commitment. If they know that under certain conditions they might be tempted to do a foolish thing, then they need to have an allocation or a solution where this is less likely to happen.

By discussing these things in advance, you are in a way inoculating people. It’s like a vaccine.

This is from a very long distance, because this is not really my field, but this is what I would like to see happen.

Noise Reduction
You’ve reached this enviable point in your career where you have the authority and the clout and the recognition to sit back and think about whatever interests you. What big questions are on your mind now?

Kahneman: I’ve done a lot of work on biases, the systematic errors that people make. In recent years, I’ve become convinced that actually there’s something more important than systematic error, and this is unsystematic error. We call that noise. There is a random element, not in the outcome, but in the making of the decision that is very significant. It’s very significant for organizations, not only for individuals.

I’ll give you the example that motivated my interest. I convinced an insurance company I was working with to run a study on their underwriters. You present, say, 50 individual underwriters with five or six realistic cases and ask them to put a dollar value on each case. I asked the executives, suppose you take a random pair of underwriters who have seen the same case, by how much would you expect their dollar values to differ? The common answer was that 10% was reasonable. You’d expect people to agree within 10%. But when you actually compute the statistics, you get 50%.

There is a lot more variability and a lot more noise than anybody was aware of. The company was unaware that it had that problem. When underwriters can differ on average by 50%, they may not be worth having. It is entirely possible that an algorithm, even an unsophisticated algorithm, will do better because the main characteristic of algorithms is that they are noise-free. You give them the same problem twice, they’ll give you the same solution. People don’t.

What I’m interested in now is restoring the balance in the way that people think of error, so that they’ll be much more conscious of noise. We always think of biases, and we don’t put enough weight on noise reduction. That’s my personal passion at this time.

Newcomb: How are we going to be able to see this work?

Kahneman: I am writing a book with two colleagues; one of them, Cass Sunstein, was a coauthor of Nudge. We hope to have a book that will tell that story and will actually change procedures. There are procedures that organizations that make strategic decisions can follow, and that people like underwriters can follow, that reduce noise.

Newcomb: Let’s take some questions from the audience.

Audience member: When people are framing current events, they often look at past historical events, seeing similarities and then rushing to judgments that the current event will be exactly like the past event. How can we counter that tendency?

Kahneman: This is the natural thing for people to do. When something happens, memory spontaneously and automatically goes to something similar that happened in the past. The answer is what I call broad framing. It is not to stop with the first idea, not to stop with the first association, but to try to expand the range of consideration to other examples, to other cases. Quite frequently, this will profoundly alter the conclusion that you reach.

Audience member: You seem to be referring to regret minimization only with respect to loss aversion. What are your thoughts on regret about missing upside or missing profit?

Kahneman: You have hit on a bias in my character: I’m a pessimist and tend to think in terms of losses. But when I was working on that, my colleague, who is a great optimist, was always talking of the other kind of regret, the missed upside regret, and of course that exists, too. It turns out that when you have two portfolios like the one that I described, one that has a very significant beta and the other that has relatively little, then one of them is likely to do better than the market. We saw that as a partial solution.

Audience member: Do you think optimism is a learned behavior or is that something that is inherent?

Kahneman: Optimism, I think, is mostly something you’re born with. It’s actually a very good thing to be born with. Optimists are healthier and happier, and optimists live longer, apparently. But you can’t necessarily control it. There are some cultural differences, though. I’m told that Hungary is a place where optimists are considered foolish. The United States has an optimistic culture, and being a pessimist puts you at some risk of social discomfort.

But clearly when big decisions are made, you want both kinds. You want the optimists and you want the pessimists, and you want an open conversation about how they’re thinking and what makes them think what they do.

Audience member: If you could go back in time and talk to a young Danny Kahneman, what life advice would you give him?

Kahneman: When I look back at my career, I think that I’ve been enormously lucky. Telling people to try to be lucky is very poor advice. Yet that’s the main thing that determines the difference between very successful careers and somewhat less successful careers. When you trace it back, you’ll find a lot of luck.


[1] Michael Lewis detailed their relationship and research in The Undoing Project: A Friendship That Changed Our Minds. 2016. New York: W.W. Norton & Co.

[2] Kahneman, D. & Tversky A. 1979. “Prospect Theory: An Analysis of Decision Under Risk.” Econometrica, Vol. 47, No. 2, pp. 263–292.

[3] 2011. New York: Farrar, Straus and Giroux.

[4] Thaler, R.H. & Sunstein C. 2008. Nudge: Improving Decisions About Health, Wealth, and Happiness. New Haven: Yale University Press.

This article originally appeared in the August/September2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.