A trader works in the S&P 500 pit on the floor of the Chicago Board of Trade of the CME Group.
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Nobel Prize-winning psychologist and economist Daniel Kahneman has published a new book that asks a question that is central to making the right calls in the markets and in money: why everyone makes such bad decisions and what can we do about them to do?
“Noise” was co-written with Olivier Sibony, a French expert on decision-making, and Cass R. Sunstein, a legal scholar and expert on behavioral economics. Kahneman is one of the founding fathers of behavioral research and author of the seminal work “Thinking Fast and Slow”.
My review of the book is here:
I met with Dr. Brad Klontz, a member of the CNBC Financial Wellness Council, put together to get his response to Kahneman’s central thesis that prejudice and noise (random variability in our judgments) are ubiquitous in our lives, but there are ways that we can use our judgment can improve. Dr. Klontz is a CFP and psychologist and author of several books, most recently “Money Mammoth” (Wiley, 2020).
CNBC: The central thesis of the book is that people – especially professionals like doctors, judges, and financial advisors – often make very bad judgments. Radiologists do not provide a consistent interpretation of X-rays. The judges do not give uniform judgments. Financial advisors are too confident in their advice. Do you agree?
Klontz: Yes. Being an expert in a particular field can make it harder to identify prejudice, be more resilient to change, and lead to greater harm.
CNBC: Kahneman says there are “bias” issues, where people are consistently focused on one point, like a bathroom scale that is always over two pounds. However, his focus is on “noise”, which he calls “random variability in judgments” where the decision-making is random and inconsistent. Why is this happening?
Klontz: Part of the problem is that people don’t recognize the randomness of their decision-making. But there are other reasons as well. Ironically, the variability of judgment has been one of the keys to our survival as a species, although it can backfire. Many decisions are not black and white. In primitive times and today, people could die from poor judgment, so there is some natural selection there.
This problem is well known in the field of psychology. For example, any attempt to measure things, such as personality traits or the effectiveness of drugs or therapies, is a random mistake. We use the scientific method and statistical analysis to reduce random errors, but it is always a threat to our attempt to understand the objective truth.
CNBC: Kahneman recommends several ways to combat bad decisions and noise. He talks about “decision hygiene” or ways to make more consistent judgments. Does this make sense?
Klontz: Yes. I love the concept of delaying intuition and not immediately reacting to your instincts. Open-mindedness is associated with success in almost all endeavors. Don’t trust your instincts. In my last book, Money Mammoth, I talked a lot about the “tribal brain,” which is the optimal way to deal with life in a group of around 150 people. This is how our ancestors lived. It helps explain why we should be suspicious of our instincts about money because the very same instincts that helped us survive and thrive in small groups under constant threat often backfire in our modern financial lives. When it comes to money, we are essentially wired to do everything wrong.
With everyone getting into cryptocurrency, we firmly believe that we should join them. On a deep psychological level, it feels like a threat to our survival not to step in.
For example, the herd instinct is good when you are in a primitive society. If everyone is fleeing from a lion, so should you. If you choose not to follow the herd and stand still, you will be eaten. Anyone who thought you should stand still while everyone else was running has been picked up and hasn’t passed their genes on to us.
While it has helped us survive throughout prehistory, the herd instinct is bad when making modern financial decisions. With everyone getting into cryptocurrency, we firmly believe that we should join them. On a deep psychological level, it feels like a threat to our survival not to step in. That is why we have to keep guessing and fighting our natural instincts. Always guess yourself, avoid over-consciousness and stay open-minded.
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CNBC: So should we have less faith in our instincts?
Klontz: We would change our world if we had less confidence in our conclusions. We keep breaking up and surrounding ourselves with people who think like us. Sometimes our beliefs are so strong that we try to hurt people who believe differently. We need to be able to observe ourselves more objectively.
Less trust would reduce conflict because we are not so anchored in our subjective conclusions.
If we spend some time between our impulses and actions, we can calm our emotional brain and activate our prefrontal cortex – the part of our brain that helps us think about the consequences of our actions. It can also give us time to seek the opinions of others.
CNBC: Kahneman also recommends that companies conduct “noise audits” that assess how consistent the assessment is in their group, whether they are radiologists, judges, or stock pickers. Your reaction?
Klontz: It’s a great idea, and the only surprising thing is that it’s not done on a regular basis. This is known in psychology. This is known as interrater reliability, which recognizes that even experts can find it difficult to agree on their analysis and conclusions. For example, the gold standard in diagnosing Autism Spectrum Disorder focuses on training to ensure reliability between assessments and to ensure that everyone comes to the same conclusion. And I totally agree that it should be done elsewhere. We should put much more work into adopting established methods in psychology and generalizing them to all professions, especially those that involve life and death decisions like medicine or law.
CNBC: Kahneman recommends a stricter application of rule-based decision making to escape random human judgment. Do you agree?
Klontz: Yes, especially if there is a clear indication of a right or wrong decision as to how this person has a tumor or not. When there are clear choices about life or death, we need to limit the variability of judgment. I mentioned the autism diagnosis. Here you need a structured, reliable and rule-based approach.
But we cannot become too rigid or rule-bound and we have to be open. We need to recognize that the rules will change as our knowledge base grows and be open to changing those rules when the facts change.
Also, remember that many decisions and conclusions in life are completely subjective. The idea is not so much to eradicate the variability of human judgment as to grapple with its existence and the idea that we are prone to misjudgment. Consciousness and humility are key. Realizing that we can make different judgments depending on the time of day or lunch is an important step in making better judgments.
CNBC: In one of my favorite chapters, Kahneman found that people, especially professionals, have a very high opinion of their own opinion.
Klontz: Yes, that has an evolutionary advantage. Suppose you are convinced that a famine is coming and the other is convinced that there is no famine. If you get a famine, you will be fine because you planned, but the other one is gone. Believing in your own opinion and believing other people to join you has helped us survive as a species.
But in the modern world there can be overconsciousness. For example, women tend to outperform men as investors. You are not that prone to overconsciousness. Men believe that they can outperform and end up being able to trade more. The proof is that they can’t. Again, a healthy dose of self-doubt can be very good for us.
CNBC: Kahneman also delves into the discussion about why everyone is so bad at predicting the future.
Klontz: We all know that you can’t predict the future exactly for the reasons that Kahneman said: We are full of prejudice and noise, and there is an ignorance about the future because things happen that cannot be foreseen.
However, this does not prevent us from giving it a try, and it is important to understand why. This desire to predict the future is also an evolutionary advantage. It is necessary to try to predict the future because it has helped us survive as a species. It is important to our survival. Those who are forward-thinking and concerned about the future may have survived in the past.
But that doesn’t help us that much in the modern age. We didn’t evolve much from “light means the gods are angry”. Most of our decisions are made by our emotional brain, and we have a relatively small prefrontal cortex that carries out rational thinking beyond a large emotional brain – and when we are excited or scared, our emotional brain kicks in and we are prone to Acts like our prehistoric ancestors.
So we cannot rule out attempts to predict the future because we think about it all the time. It is important, however, that we do not place too much weight on our predictions and realize that they are merely our attempts to understand a chaotic world. It is important that we recognize the limits of our knowledge and feel a little more comfortable with uncertainty.