For quite a while, I’ve been writing about what I think is an excessively negative and pessimistic outlook prevalent in the media, the political rhetoric, and much of our own thinking. That outlook has tended to keep us overly focused on the admittedly real things that can go wrong, and kept us from recognizing the equally real menu of things that can go right. For readers of this blog, the consequence may be that we excessively overweight investments we think might protect us from loss, and end up with too little in our portfolios that may help us benefit from things turning out better than we fear. I recently read a very good book that helped me understand why we behave this way. It’s called Thinking, Fast and Slow, and it was written by Daniel Kahneman, a psychologist who won the 2002 Nobel Prize for Economics. Professor Kahneman is one of the leading thinkers in the field of behavioral finance and has a lot to say about investing (some of which those of us in the industry may not enjoy). The book offers a model of the human mind that illuminates a broad range of human activity. Did you know, for example, that pro golfers do better putting for par than they do putting for a birdie (one stroke under par)? The book is well worth reading for this and many other insights.
Here’s how Kahneman gets us to my problem. Pro golfers actually do better when they face a possible bogie (one stroke over par) than when they might score a birdie, because we all fear and suffer from a loss more intensely than we anticipate and experience pleasure from a gain. And we tend to behave accordingly. Moreover, we tend to exaggerate the probability of plausible, but unlikely outcomes when someone tells us a story that leads to that outcome. And we tend to overestimate the probability of an event when we’ve recently encountered events like it.
So, for example, let’s say we hear about the Greek debt crisis and then about the U.S. budgetary mess, and then someone tells us a story about how the U.S. will turn into Greece before we know it, and pretty soon we’re running for investment cover. The story, of course, ignores the vast difference between the U.S. and the Greek economies, financial systems and governmental effectiveness, but it sounds just scary enough to influence us. While the U.S. may be heading for debt trouble, there’s a lot more thinking we need to do before deciding what the appropriate investment response might be. The problem, according to Kahneman, would require thinking that it is difficult and unpleasant compared to making easy connections and panicking. But it’s exactly that kind of work that’s likely to leave us with a lot less regret in the long term.
By the way, he also explains regret. But that’s another story.