Behavioral Finance and Daniel Kahneman: Decision Making in the Face of Uncertainty
Few of us are as honest about our shortcomings as Daniel Kahneman is. Yet we can all benefit from applying his insights to our portfolios. Here are lessons learned (sourced from Business 2.0 by Jason Zweig):
- Distrust data. Rather than leaping to conclusions based on scant data, look at as many numbers as possible. Don't rely just on recent performance; look at several time periods. "It doesn't take many observations to think you've spotted a trend," warns Kahneman, "and it's probably not a trend at all."
- Anchors aweigh. When pundits like Goldman Sachs' Abby Joseph Cohen predict where the Dow is heading, or when analysts like Morgan Stanley's Mary Meeker forecast Amazon.com's stock price, the market often moves magnetically in their direction. But don't anchor your expectations to the tea leaves of the so-called experts. At best, they're making educated guesses; at worst, they're manipulating you to make money for their own companies.
- Use mad money. If you can't resist the temptation to trade stocks, put the bulk of your portfolio in a broad stock-index fund; then take a little (10% tops) to "play the market" yourself. This way, you keep your hunches on the fringe, where they belong. "It's like going to the casino with only $200," says Kahneman. "It helps protect you from regret."
- Fly on autopilot. Irrational mood swings lead people to trade too much as they veer erratically between glee and dismay. "All of us," says Kahneman, "would be better investors if we just made fewer decisions."
- Look within. Most financial advice, especially on TV and the Internet, suggests that investing is an endless race to beat the market. Every day brings a breathless stream of bulletins about who's ahead or behind. If anyone else wins, it seems, you lose. But Kahneman's insights teach us something very different and vastly more profound: Investing isn't about beating others at their game. It's about controlling yourself at your own game. I'm not a penny poorer if someone in Dubuque beats the S&P 500 and I don't.
"The ultimate risk is not taking a risk."
Sir James Goldsmith