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Nov 07, 2002
Interview with Daniel Kahneman on Decision-Making under Uncertainty
Rarely do you read just a few pages which contain so much food for thought that you think for hours afterwards. Here is one such piece, an interview with one of the winners of this year's Nobel Prize in Economics: psychology professor Daniel Kahleman.
He says his main insight into how people behave was that he changed from viewing the utility of wealth to viewing the utility of gains and losses as the major factor driving behavior:
You have two people, both of whom get their quarterly returns on their stock portfolios. One of them learns his wealth has gone from $1 million to $1.2 million, and the other one learns his wealth has gone down from $4 million to $3.5 million. I can ask you two questions. I can ask you who is happier. There is no question the first one is happier than the second. Then I can ask you who is better off financially. The second one is better off. Bernoulli's analysis [Stefan Smalla: the basis for most economic analysis] was in terms of who is better off financially--basically in terms of wealth. But when people think of the outcomes of their decisions, they think much more short term than that. They think in terms of gains and losses. That was the basic insight.This leads to an interesting conclusion: When people think in terms of gains-and-losses, they tend to be much more risk-averse then when thinking in terms of wealth. As it is "rational" to think in terms of wealth, nobody ever cared to correct that mistake. Hence, traditional economic analysis overestimates the willingness of people to take risks.
Another insight Kahneman mentions is what he calls "the illusion of validity", i.e. the tendency of people to view their beliefs as reality. Or very poignantly in two of the sub-forms of this illusion of validity:
One of the versions of it is called overconfidence: People assign much higher probability to the truth of their opinions than is warranted. It's one of the reasons people trade so much in the market, generally with bad results. [Another example is people] exaggerate their confidence in their plans--something we call the planning fallacy.... The existence of the plan tends to induce overconfidence.I know exactly what he means.
More information on Kahneman and his research: Kahneman's CV, Nobel Prize information, detailed Nobel Prize information and reasons for handing out the price to Kahneman (and Vernon Smith) (PDF file).
Posted by Stefan Smalla on Nov 07, 2002 at 14:08 | Permalink