Book Review: "Thinking, Fast and Slow," by Daniel Kahneman

Posted by Brad McMillan, CFA, CAIA, MAI

Find me on:

This entry was posted on Dec 3, 2014 1:36:00 PM

and tagged On My Bookshelf

Leave a comment

Thinking, Fast and SlowOne of the fundamental principles of economics is “rationality”—the notion that all actors in a market have similar information, preferences, and abilities to project the future.

Like all economists, I know this isn’t really true, yet it still influences how I view the world. So the extent to which Daniel Kahneman proves this idea false—not just at the aggregate level, but at the individual level—comes as something of a shock.

We’re a lot more irrational than we thought

In Thinking, Fast and Slow, Kahnemanthe Nobel Prize-winning psychologist who, along with Amos Tversky, created the set of ideas that became behavioral finance—shows that the way we think is far from rational

Most of us are reasonably confident in our own abilities. Kahneman proceeds to undermine that confidence via a step-by-step process, asking readers to answer case questions and then revealing the hidden biases and errors our reactions contain. You finish the book with a newfound appreciation for just how uncertain your own mind is.

If you’re skeptical of the claims, you can examine your own reactions and Kahneman’s reasoning. You’ll probably find that he’s right and you're wrong.

Key takeaways for investors

I won’t attempt to summarize this weighty book, but several points are particularly relevant for investors.

The illusion of validity. Chapter 20 includes a section called “The Illusion of Stock-Picking Skill,” which everyone who invests should read. One of its primary conclusions is that “a major industry appears to be built on an illusion of skill.” (The italics are Kahneman’s.) You may not agree with it—and I don’t, entirely—but you should be aware of the argument.

The power of formulas. In the following chapter, “Intuitions Vs. Formulas,” Kahneman takes it a step further: “The research suggests a surprising conclusion: to maximize predictive accuracy, final decisions should be left to formulas, especially in low-validity environments.” I like this idea for a number of reasons, not least of which is that it supports my own research focus on rules-based investing.

The inside view versus the outside view. In brief, the inside view is based on insider knowledge of a particular situation, while the outside view looks at a large sample of similar situations, glossing over the specifics. Surprisingly, the outside view is often more accurate—and always worth considering.

A recent example involves U.S. interest rates. The inside view, looking at the improving economy, suggests rates might increase faster. The outside view, looking at recoveries from previous financial crises, says rates will remain low. So far, at least, rates have stayed at their low level. Score one for the outside view.

Seeing the error of our ways

Few books I’ve read have been as surprising, as interesting, and as revealing as this one. For anyone who makes decisions, Thinking, Fast and Slow will leave you wiser (and potentially sadder) as you realize the extent of your possible errors. By opening your eyes to these mistakes, in a clear and memorable way, Kahneman’s book promises to meaningfully improve your decision-making going forward.

Verdict: Highly recommended.

Upcoming Appearances

Tune into Cheddar TV on Thursday, June 20, at 9:30 A.M. ET to watch Brad talk about the market. Watch online at cheddar.com.

Tune into Fox Business' Countdown to the Closing Bell on Friday, July 12, at 3:45 P.M. ET to hear Brad talk about the market. Check your local listings for availability.

Subscribe via E-mail

Crash-Test Investing
Commonwealth Independent Advisor

Hot Topics

Have a Question?

New Call-to-action

Conversations

Subscribe

Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly into an index.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.  

Third party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided at these websites. Information on such sites, including third party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®