The Million-Dollar Mind Trick: How a Nobel Prize Winner Can Make You a Smarter Investor

[Value Research Editor's Note]( 13th April, 2024 --------------------------------------------------------------- Dear {NAME}, Every Saturday, I share my perspectives on a topic investors need to understand. Daniel Kahneman died recently. Over the last two decades, I have often referred to his research in my columns and editorials. Here’s the latest such column and links to many old ones. The mysterious mind of the investor Kahneman’s death reminds us that understanding the psychology of our own decision-making is key to success in the markets More than twenty years ago, I first heard of Daniel Kahneman, who died recently at the age of 90. This was shortly after he was first awarded the Nobel Prize for Economics (yes, I know that the Economics Nobel is not a real Nobel Prize, but let’s not be pedantic). Kahneman’s ideas, and in fact, the entire field of Behavioural Economics, came to widespread attention outside the field only at about that time. Since then, Kahneman's work, much of it in collaboration with Amos Tversky, has become enormously influential, not just in economics and finance but across a wide range of fields, including psychology, political science, and even medicine. Their groundbreaking research challenged the long-held assumption that human beings are fundamentally rational. Instead, it demonstrated the many ways in which our judgement and decision-making are subject to bias and heuristics. Let's talk about hard data for a moment. Historical data shows that while the market's daily movements are about as predictable as a coin toss, the odds of making a profit get better and better the longer you stay invested. In fact, if you hold your investments for five years, the chances of earning a positive return jump to 90%, and if you can stick it out for a decade, that number soars to a whopping 99%! At that time, I had just launched Value Research’s first print magazine, Mutual Fund Insight. We soon did a cover story on Kahneman and Tversky’s work titled ‘Out of Your Mind?’ The subhead of the article was ‘Behavioural Economics suggests that for investors, understanding their own psychology is even more important than understanding the markets.’ As stated formally, with the weight of the Nobel Prize behind it, this sounds like a new concept, and as a part of economics, it definitely is. And yet, instinctively, every investor already knows this. When you first hear it, it immediately strikes a chord and feels obvious. In fact, the core ideas of Behavioral Economics are so intuitive that they have been part of popular wisdom for centuries if not millennia. Proverbs and aphorisms from across cultures are replete with admonitions against the cognitive biases that Kahneman and Tversky identified and studied. “Don't put all your eggs in one basket,” warns against the lack of diversification. “Cut your losses and ride your profits,” cautions against the sunk cost fallacy. “A bird in hand is worth two in the bush” illustrates the concept of loss aversion. Kahneman and Tversky took this folk wisdom and subjected it to a rigorous scientific investigation. Through clever experiments and data analysis, they were able to demonstrate the pervasiveness of these biases and show how they systematically affect our decision-making, often in ways that are detrimental to our own interests. For all of us who invest, this work is particularly relevant. The financial markets are filled with uncertainty, risk, and emotional stress- conditions that strengthen our cognitive biases. Understanding these biases is the first step towards avoiding their bad effects. For example, by being aware of our tendency to overreact to losses, follow the herd, or be overconfident in our own judgments, we can consciously counter these biases and make more rational investment decisions. Of course, the implications of Behavioral Economics go beyond individual investors. The insights from this field are increasingly being applied to other aspects of personal finance, from retirement savings plans to health insurance. By understanding how people actually make decisions, rather than how perfectly rational agents would, people’s decisions may be guided, or, as the concept is called, ‘nudged’. Honestly, this is not something that I’m enthusiastic about. It’s essentially covert manipulation. Those doing the nudging may not have your best interests at heart or may not be very competent. To my mind, this whole field is best used as a personal tool to understand and improve our own decision-making. By becoming aware of our biases and mental shortcuts, we can counteract them when it matters most. This is especially crucial in personal finance and investing, where the consequences of irrational decisions can be severe and long-lasting. By cultivating self-awareness and learning to recognize when our emotions and biases are swaying our judgement, we can become better investors and better stewards of our own financial well-being. That would be the greatest tribute to the groundbreaking work of Daniel Kahneman and Amos Tversky. Here are some earlier columns where I wrote about Kahneman’s ideas. I hope you find these enjoyable and useful. July 2018: [The sunk cost idea is sinking your investments]( April 2020: [You are not irrational]( September 2020: [Random patterns and equity investing]( November 2022: [House cleaning time]( July 2023: [Fake patterns in investing]( Thank you for being a Value Research Insider. What did you think of today’s note? [Let me know](mailto:dhirendra@valueresearch.in). [vro-logo]( Copyright © Value Research India Private Limited 2024. All rights reserved. C-103, Sector 65 Noida, 201301. [Manage Newsletters]( [Unsubscribe]( [Privacy Policy]( Follow us [twitter-icon]( [facebook-icon]( [youtube-icon]( [linkedIn-icon]( [instagram-icon](