Daniel Kahneman is a very modest man — amazingly so for someone who has won the Nobel prize in economics. When I met him in the lobby of a London hotel, he never used his very great intelligence in the way that some very distinguished economists do, to bully or to intimidate. ‘But then I am not an economist,’ he says with a mischievous smile. ‘I am a psychologist.’
Prof. Kahneman smiles a great deal. His eyes sparkle behind his large spectacles. His cheeriness is infectious, but it is also disconcerting, given that he is not optimistic about humankind. He thinks, for instance, that it will be ‘miraculous’ if we manage to do anything to stop global warming. ‘Let’s suppose that the scientific consensus is correct: global warming is happening, and it will have some catastrophic consequences. By the time it becomes obvious to everyone that it’s a danger, it will probably be too late to do anything that will be effective in combating it. As a species, our brains have just not evolved to deal with threats whose effects will be felt in what, for us, counts as the remote future. We respond to them by ignoring them.’
But surely, I protest, if global warming is really happening, we can be persuaded by reasons and arguments to take it seriously, and to do what’s necessary now to diminish the effects that will come later? Kahneman smiles indulgently. Those eyes sparkle. ‘The way scientists try to convince people is hopeless,’ he states with a broad grin, ‘because they present evidence, figures, tables, arguments, and so on. But that’s not how to convince people. People aren’t convinced by arguments. They don’t believe conclusions because they believe in the arguments that they read in favour of them. They’re convinced because they read or hear the conclusions coming from people they trust. You trust someone and you believe what they say. That’s how ideas are communicated. The arguments come later.’
But he is sensitive to arguments, tables, evidence, figures, etc — so why shouldn’t the rest of us be? Again he smiles. ‘I am the same as everyone else. If I ask myself, “Why do I believe global warming is happening?”, the answer isn’t that I have gone through all the arguments and analysed the evidence — because I haven’t. I believe the experts from the National Academy of Sciences. We all have to rely on experts.’
He elaborates: ‘If you accept that view of belief, then you have to change the way science is communicated to the public. You have to recognise that people will accept scientific conclusions from people that they trust, not from anybody. Arguments and evidence are much less important than trust.’
Kahneman takes a very dim view of human rationality. Studying the way that people actually make decisions — as opposed to the way we would like to make them — led him to reject an idea that is central to the way that most of us see ourselves. We think we can be relied on to make rational decisions that will advance our own best interests. Economists have made our rationality the focal point of their work: the mathematical proofs of the efficiency of the market, so central to current economic thought, depend on the assumption that individuals will make rational choices.
But in a series of very careful experiments conducted on hundreds of people with Amos Tversky, Kahneman showed that it just isn’t true. We’re not reliably rational — in fact we can, in many circumstances, be relied on not to do what will most effectively advance our own interests.
This is not because we’re too moral or too nice to be selfish. It’s because we’re too stupid. We make silly mistakes in thinking about probabilities and risks. We think that the only factors that are going to make any difference are those things that happen to spring easily into our minds at the particular moment we’re making a decision. We are swayed by considerations that are utterly irrelevant to the matters we are trying to make decisions about: for instance, a sudden cool breeze on a hot day will lead an interviewer to think more favourably about the candidate he happens to be interviewing at that moment, and if you ask a judge to write down a high number before he enters court to sentence someone, he will end up handing down a longer sentence than if you had asked him to write down a low number, or none at all.
More fundamentally, we all tend to be wildly over-optimistic. Many of our institutions are, in Kahneman’s view, monuments to our irrational optimism. Take the finance industry, a large portion of whose business consists in taking people’s money and investing it for them. Many of us entrust a portion of our savings to someone in a finance company who promises to provide us with an above average return. It isn’t only individuals who do this: institutions such as pension funds and charities do so as well. Finance companies charge fees for taking your money and investing it for you — but they almost always fail to keep their promise to provide better returns. They frequently lose money for their investors.
So why do so many of us entrust them with our money? ‘It is not a rational decision,’ says Kahneman. He thinks the explanation is partly that we’re over-optimistic about the skills of professional investors, and partly that we’re too intimidated by the process of professional investing to figure out it doesn’t work, and too worried by the prospect that, if we invest our money ourselves and we don’t do well, we will have no one else to blame.
Kahneman was once asked by a finance firm to help its executives allocate bonuses more accurately. The firm wanted to be sure that it was awarding the biggest bonuses to the people who were best at investing: they picked the stocks that performed best, and so made most money for investors. Kahneman analysed data going back eight years on each fund manager — and found that, over that period, not one of them achieved better results than would have been achieved by chance. You would have done just as well as the professional investors, and sometimes better, had you decided what to invest in by rolling dice or flipping a coin.
To Kahneman, it was obvious that the firm was rewarding luck as if it were skill. His research should have led the firm to stop paying bonuses, or at least to a radical reassessment of how they were paid. In fact, it had no effect at all: the firm’s managers thanked him and then ignored everything he had said. Both the executives and the fund managers continued in exactly the same way, as if nothing had happened. And so did their investors.
Should we conclude, I ask him, that the whole finance industry is based on a con trick? Kahneman hesitates. ‘Well…. They believe in what they’re doing. And they know about taxes and accounting and balance sheets. They have solid knowledge to that extent.’ He smiles. ‘It just doesn’t help them pick stocks that will do well.’
So the correct conclusion is that professional investors are not insincere. They are deluded. ‘Over-confidence is the phenomenon, much more than trying to con people,’ responds Kahneman diplomatically. ‘Professional investors actually believe that they are very good value for money.’ But they are, almost every one of them, wrong about that. As we are to believe we will do better by entrusting our money to them. But believe it we do — and our conviction is amazingly resilient in the face of overwhelming evidence that it is false.
Overall, Kahneman’s research into the way we all tend to fall short of being reliably rational ought to have caused the economics profession to reappraise one of its fundamental assumptions: the assumption that we all make rational decisions, all the time. But despite his Nobel prize, Prof. Kahneman’s work has had almost no effect on the bulk of the profession. He has got used to being praised and then ignored.
‘The reality is,’ he says, for the first time with an expression closer to a frown than a smile, ‘that it is impossible to do conventional economics if you incorporate irrationality. The maths becomes too complicated.’
Incorporating irrationality into economics would also have the consequence that much of the theoretical edifice that economists have built up over the past 60 years is useless, at least as an explanation of how the actual economy works, and thus for predicting how it will behave. Few of those who have made careers constructing that edifice want to admit that it is wrong at the most basic level. So the vast majority of economists have sailed serenely on, assuming the rationality of the decisions made by the people in the marketplace, and assuring us all of the ‘efficiency’ of the results.
With hindsight, the irrationality of individual decisions was very obvious in the build-up to the crash of 2008, when banks were providing huge loans to people who had no chance of paying them back, and when many people working for the finance industry did not understand the inherent risks in many of the products they bought and sold. Alan Greenspan — the former head of the Federal Reserve, and responsible for setting the US interest rates at a level that blew the bubble ever bigger — admitted that he had been ‘shocked’ to discover that banks and finance houses did not act rationally in their own self-interest. ‘I thought Greenspan was being extraordinarily naive when he said that,’ Prof. Kahneman comments. Naive or not, Mr Greenspan was doing no more than give voice to how most economists thought then, and how most of them think continue to think now. And it shows the extent to which Kahneman’s work has yet to penetrate orthodox thinking on economics.
But in a way, that fact is simply further evidence of that he is right about the ubiquity of irrationality. ‘We’re all prone to make some very simple errors when we try to work out what to do,’ Prof. Kahneman stresses. ‘And we continue to make those mistakes even when they are pointed out to us.’ So what’s the answer? ‘I don’t have one. I don’t have a recipe for avoiding the errors we’re all prone to, and I don’t think there is one. It’s the way we are. I make the same mistakes. I try not to. But I do. I’m no different to anyone else.’