Daniel Kahneman, Thinking Fast and Slow

In a world where fast decision making and decisiveness are seen as vital skills, thinking slow might not be an attractive habit. However, Kahneman shows in his book that intuition can be misleading and hence thinking slow is not a bad characteristic after all.

Consider the following example:
A bat and a ball cost $1.10. 
The bat cost one dollar more than the ball.
How much does the ball cost?

The number of 10 cents came to my mind immediately, however this is incorrect! When the ball would be 10 cents, the bat would cost $1.10 totalling $1.20; hence 5 cent is the correct answer.

Fortunately I wasn’t the only one falling into this trap: more than 80% of students gave the incorrect answer! Apparently our intuition (Kahneman calls this system 1) overrules our systematic thinking process (called system 2 by Kahneman).

Kahneman shows that system 1 is vulnerable believing things to be true and eager to suppress doubt while system 2 tends to be lazy when it can rely on system 1 (the bat problem was an example of this). On the other hand, when dealing with non-trivial issues, system 2 is activated automatically: when calculating 13 times 17, you won’t be relying on your intuition!

Statistical biases

Kahneman demonstrates that people have biases when it comes to probability. They are too overconfident that small samples will represent an entire population: when a small sample out- or underperforms compared the overall population, this has more to do with the fact that small samples allow more outliers than that there are underlying causes for the extreme outcomes.

Furthermore, people assume too much probability to events that are widely outlined in the media like earthquakes and terrorism (bias to availability). In professional life, too much importance is assigned to talent and skill instead of luck: CEOs and traders are paid huge amounts of money, even while research has shown that their influence on company performance is limited (CEOs) or persistent out-performance over time is non-existing (traders).

Regression to the mean happens when people don’t take into account general population statistics. The size of children is in line with their parents but more towards the average size of the population: children with large parents, are larger than the average child but vary less from the mean than their parents. Golfers scoring the best/worst score on day 1 of a tournament are expected to outperform/underperform on day 2, but their out/underperformance will be less extreme than on day 1.

Another example is the negligence of base rates in statistics: instead of taking an average population statistic and adjusting this based on information, people overestimate the impact of information. A person described as an introvert is still more likely to be a schoolteacher than a librarian, simply because there are many more schoolteachers than librarians.

Kahneman also demonstrates people exaggerate the impact of skill and underestimate the role of luck. This is because people want to make sense of the world and are uncomfortable accepting their own ignorance. The result is hindsight bias in which people incorrectly claim they predicted things to happen while in fact they did not. Another interlinked issue is that people put too much emphasis on the coherence of a story line instead of checking if it is sustained by correct information and data.

Prospect theory

Kahneman and Tversky introduced psychological bias into economic decision-making problems (aka prospect theory). They developed a set of tests in which participants could choose between options and showed that people are inconsistent when making economic decisions: the so-called homo economicus, who always acts rational, assumed in classical economic theory is not applicable in real life.

Loss aversion and their starting point (aka endowment effect), prohibit people from making rational economic decisions. Fears of regret lead to inaction (e.g. unwillingness of selling stocks that decreased in value), and mental accounting stop people from taking all their financial assets into account when making financial decisions.

Why read this book? 

The work of Kahneman and Tversky has dramatically changed the science of economics in the last 15 years. Because their starting point is psychological, the book is easy to relate to: everyone is familiar with the decision problems we face everyday and the mistakes we tend to make. The book doesn’t involve advanced mathematics or the need to understand economic theory and is an ideal point of departure for anyone not heavily involved in the field of economics. As the book provides plenty of examples and illustrations, its readability is also suitable for a wider audience.

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Please note that the books I recommend are purely based on the fact that I think they are awesome and others should read them as well! No referral fees, or personal relationships (e.g. friendships or family ties) exist between me and the author(s).

About Servaas Houben

I am a Dutch actuary and worked in the Netherlands for the first 4 years of my career. Thereafter, I worked for 2 years in Dublin and 4 years in London. I am now heading the actuarial department of ENNIA in Curacao.
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