Daniel Kahneman has done as much to change the way we think about economics as anyone—and yet, he is no economist, or at least not as we would traditionally think of one. Kahneman is a psychologist; a psychologist, however, with a Nobel Prize in Economics and the acclamation for having:
"Pretty much created the field of behavioral economics and revolutionized large parts of cognitive psychology and social psychology."
To illustrate how our brain works, Daniel Kahneman devised two systems of thinking. System 1 is the unconscious thought process that effortlessly manages the majority of our behavior (generally, without error). System 2 comprises our active cognitions and requires concentrated effort to apply. System 1, unbeknownst to System 2, automatically makes a number of serial errors that Kahneman has masterfully identified.
Why all the praise? As he chronicles in his own bestseller Thinking, Fast and Slow, Kahneman's investigations into human decision-making uncovered systematic and irrational biases in the choices we make. Far from humans being the rational agents of classical economics, Kahneman was able to experimentally demonstrate the myriad ways in which we unknowingly act against our own (demonstrably) best interests—our evolutionarily-designed brains failing to cope with the complexities of modern life.
Long before behavioral economics came into vogue, savvy businessmen (nowhere more starkly than in advertising) intuitively understood the triggers by which consumers could be manipulated into modifying their behavior. Reportedly a pessimist, Kahneman would not be surprised by the desire to profit from the limitations of the human mind or the use of his insights to do so. However, an enhanced understanding of the mechanisms of human choice has also led to great advancements in public policy, health, and education—for example, simply changing the default option for an employee's pension scheme can dramatically alter savings rates, even when opting out is simple.
Nor do the business lessons from Kahneman's work need be nefarious. In fact, here are five lessons from his research that can be responsibly applied in the business world.
1. Regression to the mean
As a young officer in the Israeli Army, Kahneman was tasked with developing tools for talent assessment. While assigned to assist an instructor with the Air Force, he had a conceptual breakthrough. As he writes:
"Naturally, he praised only a cadet whose performance was far better than average. But the cadet was probably just lucky on that particular attempt and therefore likely to deteriorate regardless of whether or not he was praised. Similarly, the instructor would shout into a cadet's earphones only when the cadet's performance was unusually bad and therefore likely to improve regardless of what the instructor did."
What the officer thought was evidence of the causal impact of his punishment—yelling after a poor performance leads to a better subsequent performance—was actually the natural regression to the cadet's typical performance as part of the natural and random variations in human endeavor. The insight that our performance fluctuates around an average, and that large deviations will be followed by a return toward this average, is referred to as regression to the mean and it is ubiquitous (and oft misunderstood) in everyday life.
Kahneman offers another example of this phenomenon creeping (misunderstood) into our thinking through a conversational experiment. Kahneman would state the following proposition:
"Highly intelligent women tend to marry men who are less intelligent than they are."
Asked to explain why this is the case, highly educated respondents will generate causal explanations like, "intelligent men don't want intelligent women." Kahneman would then ask the respondent to consider the following statement:
"The correlation between the intelligence scores of spouses is less than perfect."
Both statements are true, but less intuitively, they also make the same point! If there is not Orwellian assignment of spouses based on intelligence, then of course, on average, highly intelligent people will marry less intelligent people—there are far more of them! So, how does this apply to business?
In forecasting performance, it is important to first identify a base rate: the probability of a specified outcome across a relevant population. If you want to know the likelihood of your restaurant staying afloat for two years, start by looking at the average for all restaurants before adjusting to account for other factors. If you are forecasting next year's profits at a series of retail stores, adjust your expectations down for store's that performed unexpectedly well the previous year and adjust your expectations up for store's that performed unexpectedly poor the previous year.
2. The dangers of overconfidence
When are we confident? According to Kahneman, it is when we can effortlessly recall a coherent narrative of a similar situation. Unfortunately, most of us selectively internalize fanciful stories that discount the role of luck and produce unwarranted confidence. For Kahneman, three things must hold for us to be confident in predicting behavior:
1. An environment must be sufficiently regular to be predictable.
Unfortunately, many experts tend to inflate their confidence in prediction because they believe too strongly in a narrow worldview and explain away unaccommodating variations (traits of what Isaiah Berlin dubbed the hedgehogs of the world) or they simply neglect base rates.
Because of the three rules of prediction, few fields allow for confident assessments of the future (although events in the near-future can sometimes be forecast). Kahneman cites the work of Philip Tetlock to show the perverse relationship between expertise (particularly when it is publicly recognized) and forecasting. He writes:
"Those who know more forecast very slightly better than those who know less. But those with the most knowledge are often less reliable. The reason is that the person who acquires more knowledge develops an enhanced illusion of her skill and becomes unrealistically overconfident."
In a world where high-specialization is valued over general knowledge, Kahneman surmises that a regular reader of The New York Times is likely to be equally good at forecasting political and economic events as a star PhD who loses his humility.
This is not to say that you shouldn't attempt to predict the future, but rather, that you need to be careful in how you go about it. First, it is important to avoid the planning fallacy: a tendency to be overoptimistic in planning and disregard similar groups' experience with a similar task. In all likelihood, you are not as uniquely talented as you think and you should begin by looking at the experience of others.
Second, in low-validity environments (where prediction is difficult) you should rely on carefully constructed formulas over expert judgement for predictive power. Where prediction is hard, human inconsistency will naturally lead to different variable weightings at different times. A carefully constructed formula, that consistently weights known correlations, will on average outperform its human competitors.
3. Bad events
Almost no one will accept a 50/50 gamble to lose $100 or gain $100. More surprisingly, most people will reject a 50/50 gamble to lose $100 or gain $150 (assuming a modest base income). This is because we have evolved to be loss averse—we prefer the status quo to a likely gain when its does not overwhelmingly outweigh an unlikely loss. In fact, Kahneman cites estimates for a Loss Aversion Ratio of between 1.5-2.5x (that is, the gain needs to be more than twice the loss for us to accept a gamble). Kahneman writes:
"The brains of humans and other animals contain a mechanism that is designed to give priority to bad news. By shaving a few hundredths of a second from the time needed to detect a predator, this circuit improves the animal's odds of living long enough to reproduce... no comparably rapid mechanism for recognizing good news has been detected."
The fear of bad results dictates our behavior far more than the fear of missing a promising opportunity for good results. For example, the economists Devin Pope and Maurice Schweitzer found that, after controlling for distance, golfers putt significantly better for par than birdie. The fear of a bad result (a bogey if they miss their par putt) improves the golfer's concentration in a way that the rewards of a birdie putt do not.
Our tendency to avoid bad events can lead to a number of negative outcomes in business. We are likely to be plagued by the Sunk Cost Fallacy: having already thrown money into a project, we are unwilling to accept a loss in the face of concrete evidence to move on. Instead, we will create a much bigger failure later by prolonging its realization rather than conducting an impartial cost/benefit analysis of the current predicament. We are, irrationally, more likely to gamble (throwing money against long odds) when faced with the prospect of a definite loss—Kahneman argues that this is why countries keep fighting at great human cost even when defeat seems imminent.
Similarly, when reforming an organization, big losers will be far more motivated to resist change (if say, their jobs are at stake) than a larger number of small winners will be to promote it. To counter this, remaining aware of the natural bias against loss can help us to seize and strategically-frame promising opportunities and deflect against unwarranted gambles that seek to avoid (a relatively) small loss.
4. Risk policy
What is rational for the individual is not always what is rational for the group. For Kahneman, this is evident in the way organizations manage risk. Too often organizations narrowly frame a single decision in a way that would be suboptimal if it were considered in conjunction with all other similar decisions. He writes:
"A risk policy is a broad frame...The relevant issue is your ability to reduce or eliminate the pain of the occasional loss by the thought that the policy that left you exposed to it will almost certainly be financially advantageous over the long run."
A risk assessed individually may seem unworthy of a gamble—you probably wouldn't accept a 50/50 bet that wins $110 and loses $100. However, would you accept it if you knew you could accept the same wager 100 times? Or 1000? Certainly you should, but unfortunately we often fail to take the long view.
Kahneman finds that experienced traders are regularly able to ignore their fear of an individual loss and choose the increasingly favorable payout of a series of equally likely bets over the long-run. In this light, Kahneman advises accepting the risk of a gamble if the following three points hold:
1. "...the gambles are genuinely independent of each other; it does not apply to multiple investments in the same industry, which would all go bad together."
For businesses, if your strategy is sound, you should avoid monitoring the daily fluctuations of your outcomes—you will remember the losses more vividly than the wins and unjustifiably alter a behavior that may be financially strong over time.
Likewise, you should encourage individual managers to take sensible risks. While each risk may seem unpalatable within a given department, when aggregated across the company the gambles may be unambiguously beneficial. Generally speaking, think broadly and group your decisions into a single risk strategy!
Marketing and experience
If the details are present, how a proposition is worded shouldn't matter—and yet it does. The context in which you confront a problem matters even when you are an expert in solving it. Kahneman illustrates the power of framing (the where/when/how of a proposition) through an experiment on physicians at Harvard Medical School. He writes:
"The five-year survival rates |for lung cancer| clearly favors surgery |over radiation|....|Faced with advocating surgery or radiation|, half |the participating doctors| read statistics about survival rates, the other half received the same information in terms of mortality rates. The two descriptions of the short-term outcomes of surgery were:
Of course, the two propositions are identical. However, just by flipping from a positive wording (90% survive) to a negative one (10% die), the experimenter was able to significantly influence the decision-making of elite doctors. Why? Because without careful deliberation we operate as emotional creatures—and the negative prospect scares us into suboptimal action. It would be simple to reframe the 10% mortality rate as a 90% survival rate and yet only the most conscientious thinkers are able to do so.
We are similarly susceptible to anchors—gauging an estimate or decision based on a given reference category. Unfortunately, often we are given erroneous anchors or none at all. Kahneman cites the debate over differential pricing at gas stations for cash and credit payments. He writes:
"The credit-card lobby pushed hard to make differential pricing illegal, but it had a fallback position: the difference, if allowed, would be labeled a cash discount, not a credit surcharge....people will more readily forgo a discount than pay a surcharge."
By anchoring credit payments as normal and making cash payments worthy of a "discount", the credit-card companies were able to remain competitive in the retail gas market. Not only can our decisions be altered by the way words trigger our emotions, but by when and how intensely they trigger them in the decision-making process.
As humans we are our "remembering self" and not our "experiencing self". When thinking back on a particular experience, Kahneman finds evidence that humans are biased in favor of the single most intense moment of an experience and the end of an experience—almost entirely neglecting the experience's duration. This can lead to damning results. Kahneman cites evidence that found that humans will undergo more pain for a longer duration if it ends pleasantly than the same pain for a shorter duration if it ends unpleasantly.
For businesses, when marketing and creating a user-experience, it is important to pay careful attention to how you frame, anchor, and structure your product. Customers will remember their emotional response at peak intensity and at the end—you should adjust accordingly.
Please fill in the contact form below to have new articles emailed to you directly!