Can we ever trust instinct?

By A.B. | LONDON

DANIEL KAHNEMAN is the Eugene Higgins Professor of Psychology Emeritus at Princeton University and Emeritus Professor of Public Affairs at the Woodrow Wilson School of Public and International Affairs. He was awarded the Nobel prize in Economics in 2002 for his pioneering work with Amos Tversky on decision-making and uncertainty. He is the author of “Thinking Fast and Slow” (2011), reviewed in The Economisthere.

What do we need to know about applying psychology to economics?

The realisation that people do not always make the sensible decisions that they would wish to make has implications for policy. This is where the major success of “nudges” has been reported. In the domain of personal investing there is very clear evidence that individuals, unless they have access to illegal information, should not trade in stocks because following their judgement costs them money. To reduce the incidence of costly mistakes, the choices offered by institutions and governments should be structured by providing people with a reasonable option from which they can opt out. Another hotly debated issue that arises indirectly from psychological research is the use of measures of well-being to help guide policy. In the UK the intellectual leader of the movement is my friend Richard Layard, and he and I don't quite agree on the direction this should take. He is much more of an optimist than I am, and he would favour measures that would improve the happiness of the population, whereas I am more of a pessimist and believe that it should be the objective of policy to reduce suffering, which is not the same thing.

Suggested reading: "Nudge: Improving Decisions About Health, Wealth and Happiness", by Richard H Thaler and Cass R Sunstein (2008)

How would you reduce suffering?

First you need to identify where the suffering is. Private grief is not something that the government has much business getting involved in, but I would focus on emotional suffering, and physical suffering too.

Would you equate those with poverty?

They are not identical with poverty, though poverty has a great deal to do with them. Poverty is clearly one source of emotional suffering but there are others, like loneliness. A policy to reduce the loneliness of the elderly would certainly reduce suffering. In the UK, of course, you have the precious institution—the pub. People should be conscious of the large contribution made by anything that gets people together easily in the reduction of loneliness and emotional well-being. Another focus should be mental illness, which is a major source of suffering. Richard Layard has done marvels in this domain, by increasing the support for treatment of the mentally ill. For many people, commuting is the worst part of the day, and policies that can make commuting shorter and more convenient would be a straightforward way to reduce minor but widespread suffering.

Suggested reading: “Happiness: Lessons From a New Science”, by Richard Layard (2006)

Why don't people make good decisions that reduce suffering for themselves?

This is the debate that makes psychological issues relevant to policy. If you assume that economic agents are completely rational, two immediate conclusions follow. One is people don't need to be protected against their own choices—and that has been very explicitly the line of the Chicago economists, as illustrated by their opposition to social security. I think the evidence against perfect rationality is overwhelming. A large proportion of the population wants to save more than they do and they have firm intentions to start saving next year. Helping them do this will actually help them make the decision they wish they would make.

Another pernicious implication of the assumption of consumer rationality is that individuals need little protection from the firms with which they interact. For example, the law requires truthful disclosure, but there are no regulations about the clarity of the disclosure or about the size of the print. The assumption is that rational agents will make the effort to read the small print where it matters but, in fact, most of us don't. Nobody reads the disclosures that roll down your computer screen. You click ‘I agree' but you don't know what you're agreeing to. In the United States, especially under the influence of Cass Sunstein, the White House regulatory chief, firms are required to produce information for their clients in a form the clients can understand. I don't see that this has any drawbacks, except for the corporations. Those changes in, for example, mortgage and credit card regulations have been fought by the industry, which means the industry thinks it is to its advantage to keep customers poorly informed.

Could you describe the research that shows how irrational we are in our decisions about these things?

There is a vast amount of research that shows that opting-out policies lead to a much increased level of saving and a higher level of satisfaction. In the domain of individual financial decision-making there is research by Terrance Odean on what happens to individual investors. By and large, whenever individual investors buy or sell a stock they buy and sell the wrong stocks and financial institutions benefit from these mistakes. The cost of having an ‘idea' is nearly 4% for an individual investor. There is research showing that men have more of these ‘ideas' than women do, so women are more successful investors than men (on average) because they churn their portfolios less. As Odean and Barber have observed, Individual trading is hazardous to people's wealth.

Suggested reading: “Just How Much Do Individual Investors Lose from Trade?” by Terrance Odean with Brad Barber, Yi-Tsung Lee and Yu-Jane Liu, Review of Financial Studies, 2009, Vol. 22, 2, 609-632

Sometimes we can and should trust our intuition, surely?

Most of the time we can trust intuition, and we do. In terms of the distinction I draw between fast thinking and slow thinking, our life is mostly run on fast thinking, which normally does very well. We cross the street safely and make many other decisions safely. However, there are situations where people would do better by slowing down. And there are cases in which people have far more confidence in their intuitions than is justified, as in the case of stock trading.

So everyone needs to be protected against intuition?

The mortgage crisis is a clear instance of consumers who needed protection. There was predatory lending to people who didn't know what they were doing. We haven't yet found the right model to look at decision-making under fear, how people react when the world feels dangerous and uncertain.

What about Freud on group psychology? He's quite clear about people handing over their egos to the leader.

Well, clearly there is a state when we lose our normal grasp on reality, which is mostly defined by what other people do. Under some conditions, people and institutions come to be guided almost exclusively by the worst-case scenario. This can happen at the level of institutions, when banks become afraid of lending to other banks. Understanding these processes is very urgent. We have vague stories but we don't have good research of the kind we have on individual risk taking.

Nassim Nicholas Taleb said his next book might be called: How to Live in a World we do not Understand. I think that is perfect.

Suggested reading: "The Black Swan: The Impact of the Highly Improbable", by Nassim Nicholas Taleb (2007)