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Nobel Prize Winner Daniel Kahneman: Lessons From Hitler's SS And The Danger In Trusting Your Gut

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Daniel Kahneman is Professor of Psychology and Public Affairs Emeritus at Princeton University's Woodrow Wilson School and the 2002 winner of the Nobel Prize in Economic Sciences. I recently sat down with Kahneman to talk about how his prize winning theories apply to investing. Video and a transcript of our conversation follows.

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Steve Forbes: Dr. Kahneman, very nice of you to join us today. And before we get into the implications of your work for people who think they can do well in the stock market, by their own genius, please recount the story of your first lesson in irrationality in Paris, 1941, early-'42. German occupied, you're Jewish, you have to wear the Star of David. Tell us what happened as a young child.

Daniel Kahneman: Well, I was a seven-year-old boy, and there was a curfew for Jews, and indeed, I had my sweater with the Star of David on it. I stayed too long with a friend, and I was past the curfew time. So I put my sweater upside down, and I walked home. And very close to home, I still remember the place, it's a suburb of Paris, I saw a German soldier walking towards me, and he was wearing the black uniform, and black uniforms meant a lot. I mean, those were the SS, they were the worst of the worst. So I knew that one should be afraid of them.

Then he beckoned me, he called me, and I went up to him, and he picked me up, and I remember very vividly being terrified that he would see inside my sweater, that I was wearing the Star of David. Then he hugged me, and he put me down, and he took out his wallet, and he showed me a picture of a little boy, and he gave me some money.

So that was a father, and I reminded him of his son. And I remember sort of the astonishment, the complexity of it. I was a seven-year-old boy, but that was telling you that life was very complicated, if killers could behave like that.

Forbes: In the rest of your stories, you've said yours had a relatively benign outcome. But moving in France, and how your father was arrested and then sprung out.

Kahneman: Well, my father was the chief of chemical research in a large French concern. In fact, it was part of L'Oreal, which is very well known these days. He was protected during the war to every extent possible. He was picked up and sent to Drancy, the famous place where Jews were sent, and ultimately from where very few people returned.

But he was released, and it turned out that through the intervention of a man [Eugène] Schueller, a very complicated story, I never knew the details, but it involves some German officer and a woman who was in love with him, and all sorts of things. But many years later, I learned that Schueller – whose daughter [Liliane Bettencourt] is famous, she is the richest person in France, actually. Schueller had been the main funder of the fascists in France before the war, and it was a virulently anti-Semitic movement. But he liked my father, and he protected us to the extent he could. We got packages of food from them throughout the war, even after my father died.

Forbes: Amazing. So you learned at an early age that the human mind is not a simple thing.

Kahneman: Definitely.

Forbes: Now, before we get to the implications for investing, one of your early tasks was in Israel, where you were born, what became Israel, was to try to pick out people who were good officer material for the army. And what did you learn from that process?

Kahneman: I learned a lot from that process. It was very influential in the work I did later. We would give field tests to people who wanted to be officers, they were candidates for officer training, and there were field tests. There people would be given a task, a difficult task, a physical task, like pick up a log and use it to pass over an obstacle.

We would watch them in action, they were in groups of eight, and the stunning thing is when you watch a thing like that, you see personalities, it's just very, very convincing, and so we saw them in action. There's a feeling you get a real direct access to how good the person is, as a leader, each one of them.

Some leaders and some wimps, you see all characters. But then about once a month, we would have the Friday of statistics on the last day of the week, and they would come and tell us how well we were doing, in predicting success in officer training. And the fact was consistently, we were not doing anything. I mean, we were just guessing. What we were seeing had nothing to do with reality. But the striking thing, and which influenced my work a lot, is that even after you're told statistically that it's nothing, that you can't do this, you cannot predict how well they'll do. The next Sunday, there is a batch of people, you take them to the obstacle course, you watch them, and you see them just as clearly as ever. So this disconnect between knowing that there is something you can't do, and feeling that you personally can do it, that's been with me all my life, and I think there is a lot of it on Wall Street.

Forbes: You won a Nobel Prize for fathoming the human mind. You've made the point that perhaps because there are so many smart people in finance, that individual stock pickers, managers, cannot consistently beat the market.

Kahneman: Well, it's not a point I made. The point, I'm not a finance expert, so you know.

Forbes: Well, clearly, they're not either.

Kahneman: Well, when it comes to stock picking perhaps nobody is. That certainly was [Burton] Malkiel's (PH) point. So, I am the consumer of this stuff. But what I find very interesting is that although everybody, I think, recognizes that in principle, you can't do this. Because if you could pick stocks very well, then other people would also be picking those stocks, so the advantage would be gone. So everybody realizes that in principle, it's impossible. But everybody personally thinks they can do it.

Forbes: Like your officers.

Kahneman: Yeah. And that's exactly like the officer story. That, I find fascinating. I call it an illusion of skill. You know that it's wrong, but you feel something else.

Forbes: And why does that persist?

Kahneman: It persists because you get the immediate feeling that you understand something. That is much more compelling than the knowledge of statistics that tell you that you don't know anything. And, that again, is the officer story. But it's writ large, that you really see it at work in many domains. In the financial domain, where people feel that they can do things that, in fact, we know and they should know they can't do.

Forbes: Now in one sense, that would lead an investor to throw up his or her hands in despair. Does that mean they should just go to index funds? But you make the point, no, you just don't be passive.

Kahneman: Well, I actually am a believer in index funds. I think all behavioral economics, say if you don't have very specific information, which some say you're not allowed to have, you better not kid yourself that you can pick individual stocks.

There are many niches in finance. This is not a general conclusion about finance. Because obviously, there are many domains in finance, where there is information that you can pick up quite legally here that will enable you to do better than other people. But that doesn't seem to be true in the stock market proper.

Forbes: You made the point then, when it comes to investing, that instead of asking how much do I need to make, or should make, or can make, your first question you should ask yourself, how much can I lose?

Kahneman: Yeah. I think one of the major results of the psychology of decision making is that people's attitudes and feelings about losses and gains are really not symmetric. So we really feel more pain when we lose $10,000, than we feel pleasure when we get $10,000.

And that asymmetry is just a fact of life. And it affects professionals much less than individuals, because professionals play a repeated game. So, you know, you win a few, you lose a few. Once you have that attitude, you're okay, or you’re better off.

But individual investors feel losses very keenly, and they should be aware of that. And what happens is if you're not aware of that, when things go bad, you'll want to change what you're doing, and that's the disaster in investing, I think. That's here, it's quite obvious that loss illusion can kill you.

Forbes: Well, Burton Malkiel, whom you referred to a few minutes ago, makes the point if you are consistent, you will do fine, the market will rescue you. Emotions are your enemy.

Kahneman: Emotions are, indeed, your enemy. The worst thing that can happen to you, of course, is to bail out, to make a decision and then not stick with it, so that you bail out when things go badly, so that you sell low and you buy high. That is not recipe for doing very well in the stock market, or anywhere.

Forbes: What can financial advisors then do for people?

Kahneman: I think they have a lot of expertise that is relevant. But we should know what they can do, and what they can't do. I think they know about taxes much better than most other people do, and taxes are a very big deal. They know about fees much better than other people do. So I think they're worth going to. There is a lot that they know that you can use. But when they start telling you that they've heard this wonderful thing about this stock, you might seriously consider another financial advisor.

Forbes: Now I think you make a distinction too between, and these are my words, not yours, between money, serious money, such as for retirement, and what you might call mad money, or money that you can suffer a loss, and not destroy your lifestyle.

Kahneman:  I was consulting, and still am, with a financial firm, Guggenheim Partners, and there, it's a doctrine. When you deal with very wealthy investors, the question is, of your wealth, how much are you willing to put at risk? How much are you willing to lose, in fact? Because this is money you should be prepared to lose. And how much do you really want to protect? Now, this is something that people find very natural, that distinction. And then they find it very natural to be quite conservative with the amount they want to protect, and to be fairly bold with the amount they are willing to lose. It's not optimal wealth maximization.

In a way, it's completely artificial, because ultimately, it's their wealth, it's one pocket. But psychologically, people have mental accounts, and they want to feel safe on one big sum, and they're willing to gamble on another.

Forbes: You make the point that if somebody finds a way to do well, it attracts imitators. We see it with hedge funds, equity funds. We did a story on Mitt Romney, what he did at Bain in the early years was unique, eating their own cooking. They just didn't take over a company; they went in and managed the company. Others picked up on that, so their advantage was lost. Is that true of most investing strategies?

Kahneman: It is almost bound to be true of investing strategies. One of the things that is very remarkable, actually, about your program, about this program, is the number of optimists there are who come and tell you a way to get rich. You know, they should be getting rich. They shouldn't be telling other people.

Forbes: Is there anything to the idea of people who've done well over time, and you make the point, five years is not a good measure, that when a smart manager has a cold hand, is that the time to go in? Long term players.

Kahneman: When you talk to managers, yeah, in the first place, five years is really nothing. I mean, people who go by the record of five years just don't understand statistics. They don't know how many funds there are. There are just so many things out there that by chance alone you're getting to get five good years. That tells you essentially nothing. There are some seriously long streaks, so no one that I know in behavioral economics, and this is not in behavioral finance, this is not my field. You know, I'm not a financial expert. But nobody's willing to swear that there aren't some people who have some advantage. But certainly, most of the people out there, who are dealing the stocks and making decisions, they're no better than chance. They're throwing darts, and they don't know it.

Forbes: And that's because the market, in this sense, is efficient?

Kahneman: Well, it's efficient in that sense. It's not efficient, necessarily, in the sense that it predicts the future. But it's efficient in the weak sense, in that you can’t do better than it.

Forbes: Reminds me of a story of a money manager in Connecticut who, years ago, would say you should do investing the way you should play tennis. He said, "Get over the fact that you're not going to play as a player in Wimbledon. Focus on just getting the ball over the net. Don't try to be fancy, just get the ball over the net." So investing should be the same thing. Take the narrow view.

Kahneman: I mean, it's obviously, again, if you have money to gamble, and if you have feel secure enough in what you're going to have at the end of the day, then you can play. And playing is enjoyable. And that should count for something. What should count for something is emotion.

That’s how we live. So you want to be, to live the life that you enjoy, you want to feel secure, you want to sleep well at night. You don't want to feel regret. So my main advice to investors is know yourself, in terms of what you could regret. Because of what you might regret, if you're regret-prone, there are certain things you just shouldn't do.

Forbes: Now, the implications of your work on economics, where overlooking human nature, they consider this rational, whatever that means. What are the implications of your work, your findings in terms of economic modeling?

Kahneman: Well, this is a complicated story. And again, one in which I'm out of my expertise. I mean, I am a psychologist, so I don't do economic modeling, you know, and I hear about it, but I don't do it.

Forbes: You're saving your time.

Kahneman: No, you know, I'm doing what I know how to do mostly. But there has been modeling, and I think the one area of progress is behavioral finance. Otherwise, you know, behavioral economics is widely recognized as, it's important. In microeconomics, it's important in some policy. But we're not using behavioral economics successfully to predict what the market will do. This hasn't happened yet, and may never happen. But there are, in behavioral finance, certainly where, you know, the fate of the decision making of individuals interact with those of organization, there is a lot that we know. And a lot of successful modeling, I think.

Forbes: But in terms of the economy, as a whole, that's beyond?

Kahneman: It hasn't happened yet. You know, I'm not an expert, but clearly, it hasn't happened yet.

Forbes: What, then, in terms of your findings, what implications does it have for economic policymaking? Is it, again, is it a fool's game to think if we do this, we get Y, may not get Y?

Kahneman: Well, I think that in a way, the implications are largely negative. I'll give you an example. I mean, it's clear that in economic theory, there was the assumption that institutions act like rational agents. Well, institutions are not agents. They have executives in them. What's that famous saying of Alan Greenspan, that his framework was wrong.

What this framework can be, whether banks can be trusted to protect themselves. Well, banks are run by executives, and executives protect themselves, and that does not always mean that banks are going to behave rationally.

So that there, this is standard economics, the agency problem and the difficulty of aligning incentives. But behavioral economics is right there, and can be helpful in figuring out what are the true incentives, and what kind of mistakes people are most likely to make.

Forbes: So as you've pointed out in investing, five years is not a good period.

Kahneman: No.

Forbes: In judging the effectiveness of a CEO, a short period of time is highly misleading. Can be highly misleading.

Kahneman: Typically, we find it very difficult to separate our impression of the CEO from our impression of how well the firm is doing. So the same behavior exactly would look firm in one context, and stumble in another, and there's nothing we can do about that.

This is really the way the mind works. But we ought to be aware of it, and we ought to be aware of the fact that hindsight is very important, and that what we call the halo effect, forming a general impression, that's very important, plays a big role.

Forbes: Now you make the point in your work that we have really two parts of the mind, in essence. The fast, visceral one helps us survive, and the more rational one. Can you briefly describe that?

Kahneman: I call them System One and System Two, or fast thinking and slow thinking, but it's really way of pointing out that we, just in the way that we perceive the world, we don't have to decide. I don't have to decide to see you. I see you as I see you, you see me. That happens to us.

Many ideas happen to us. We have intuition, we have feeling, we have emotion, all of that happens, we don't decide to do it. We don't control it. Then there are periods where we reason, where we think more slowly, more deliberately, and that's critical. We think we reason more than we actually do. There is a lotof what we think is thinking, is actually finding justifications and rationalizations for things, our fast thinking tells us what to do. So it's that part that is really the dangerous part. We don't know our own minds.

We think, each of us, that we're much more rational than we are. And we think that we make our decisions because we have good reasons to make them. Even when it's the other way around. We believe in the reasons, because we've already made the decision.

Forbes: You give a couple of examples that have hit you over the years of people confusing fast thinking and what you call slow, deliberate thinking.

Kahneman: There is one really remarkable thing, and everybody is quite aware of it. Why has nobody ever trained their mind on political issues? You know, we've got people talking to each other all the time, and exchanging arguments. And both sides on any argument feel that their arguments are completely compelling, and should lead the other side to yield, and they don't. And what that really tells you is that neither side believes what they believe because of the arguments that they raise.

They believe in the arguments because they hold those beliefs. It really goes the other way around. We find that everywhere in many, many places. It's not universal. I mean, you know, when I decide whether to take a taxi or go by subway, I don't have deep feelings about it, I make a rational calculation of cost and time, and so on. But many other decisions are really driven by emotions, and they're driven by impressions that we have no control over.

Forbes: So when you do get political decisions made, and a new consensus emerges, it's more from emotion than from somebody saying, "Aha, I'm reconsidering my position because of one, two, three, four."

Kahneman: I think. You know, it's much more emotion than you know, there are some people who are convinced by facts, and you know, at the margin, we pretend to be rational when we argue. And that is a good pretense to maintain. And sometimes we reach each other. But much less than we think we will.

Forbes: And getting back on the stock picking. There is a place for Graham Dodd in the world?

Kahneman: Well, you mean Dodd-Frank?

Forbes: Graham. Benjamin Graham.

Kahneman: I mean, is there a right way of doing things? Well, my guess is the following: that there must be some, there are experts. You know, everybody talks about Warren Buffett, and so he comes up whenever I have a conversation about this. But Warren Buffett is very, very clever and there are many things that he can do. And in addition, you know, beyond a certain point, he starts moving markets so that he is...

Forbes: Self fulfilling?

Kahneman: He is self fulfilling. And, you know, one has to be very lucky to get that far. But beyond that point, the fact that you keep on being successful is less impressive, in terms of nobody can say, "Well, I'm going to be successful by doing the kind of thing that Warren Buffett does." I think many, many people have tried, and there aren't many Warren Buffetts.

Forbes: It's like, the green thumb in the garden.

Kahneman: Yeah.

Forbes: In terms of then closing on the career, a lot of smart people go into finance, and what the implications of what you found seem to be, you're not going to get a huge advantage very long, you should go, perhaps, in an area where you don't have those small incremental gains, you can really make a, to use a Chinese phrase, great leap forward.

Kahneman: Well, you know, the odd thing is there is a very big industry out there, and it's possibly less helpful than it pretends to be, but many people believe in it. And a lot of it is self fulfilling.

And so, you know, I wouldn't advise people not to go into finance because people in finance, by and large, are doing way better than people in many other places. So I wouldn't I would just say the reality is that you have a lot of people who think they have very smart ideas, and they're getting paid for thinking that, not necessarily for having smart ideas, but they're being paid for, for having ideas that convince other people. So some of it is an illusion. And it is interesting, I think, it's an honest illusion.

I mean, I absolutely do not have that theory that people are devious about this. People deceive themselves, and it's the people who deceive themselves the best who have the best opportunity to mislead others, quite a lot innocently. That's sort of my view about what a lot of what happens.

Forbes: In closing, on going back to your experience, and trying to pick officers or people who would make successful officers. Have you concluded there's no systemic way to do it?

Kahneman: Well, no. I mean, that would be rash. There are certainly some people do better than others.

Forbes: Or is it more just seeing who you know is not going to be successful?

Kahneman: There are people who clearly, that is a big help, knowing who's not going to be successful. Going by past performance. The main thing is the people that you think are going to do very well, on average, are going to do less well than you think. That's a fact that you have to accept.

So you do the best you can, and it's not that there's nothing we can do. We know something about people, so we have a chance to pick some people. We certainly have a chance to reject those who won't do well. And maybe try and pick some people who have a good chance or an opportunity to do well. By and large, the people that we think the most of, statistically will disappoint us. This is a fact of life.

Forbes: I guess one prime example in the U.S. is, we were discussing earlier, Hyman Rickover created the nuclear submarine fleet in the U.S. against formidable odds. And then in some ways, he was not a good commander of men and ships, but he did amazing things for the Navy.

Kahneman: Well, what happens is, that occasion fit between the characteristics of an individual and the characteristics of the situation, and that was his story, I think. He was ideally fitted to force an idea. He was stubborn, he was opinionated.

He was also very smart, and in a way that people could pick out that he was smart. And so he knew things that other people didn't. And that enabled him to do things that other people couldn't have done. You wouldn't have guessed that. It would've been very bad if he had been excluded at an early stage. In a way,   if the system had been sensible, it would've excluded him, and that would've been a great pity.

Forbes: I guess you see that in business. Steve Jobs' biography.

Kahneman: Absolutely.

Forbes: A very difficult personality, and some early setbacks, but he emerged as a formidable leader.

Kahneman: Absolutely. And anybody who thinks that they can duplicate what he did, most of the people think that they can duplicate or even come close, will never succeed. You know, there was an element of luck, and there was a very large element of a unique personality.

Forbes: Doctor, thank you, and the book is Thinking, Fast and Slow, well worth the read. Thank you.

Kahneman: Thank you very much.

Steve Forbes is the co-author of Freedom Manifesto: Why Free Markets Are Moral And Big Government Isn’t.