Thinking, Fast and Slow

(click the title above to see a video review of the book by me)

By Daniel Kahneman

This is a book review of Thinking, Fast and Slow by Daniel Kahneman. I first became aware of Daniel Kahneman and his work in mid 1990s. I am a computer scientist and at that advised large companies on making decisions analytically and rationally. Their work shook my belief system. The basic premise of their work is that humans are not rational agents, at least not all the time. They make predictable, and repeated errors in judgement.

Since then Kahneman has won the Nobel Prize, a new area of finance and economics called Behavioral Economics is now being taught in many universities and I have gained 20 years of business and life experience to know first hand how everyone, including me, is susceptible to these biases.

So I have two objectives for this review. The first is to provide a quick demonstrations to prove that we (and that includes you as well) are not consistently rational.

First example,

If you were presented with a gamble which offered

1. A) Sure gain of $490
2. B) 50% gain of $1000 and 50% gain of 0

What would you choose?

Now choose between

1. C) Sure loss of $490
2. D) 50% loss of $1000 or 50% loss of 0

Most people will pick A and D. Now take out a paper pencil and work out the math of choosing BC versus AD. BC is better than AD. However, we regularly chose AD! The expected value of AD is $20 less than BC.

The books is filled with dozens of examples of such examples. Many studies have been conducted on Ivy league students, business executives, highly educated professionals and shown that their decisions are inconsistent with what we would expect from economic rationality.

The key new theory proposed (and now widely accepted) is called Prospect Theory. Prospect theory makes three basic additions to our understanding

— People are more averse to loss than they like same amount of gain. Losing $100,000 is a lot more painful then gaining $100,000.

— People reference gains and losses relative to a neutral point, rather than absolute amounts. This reference happens automatically based on our past experience and sometimes unrelated recent exposures. Even a random number flashed on a screen just before asking a question can influence the answer. Example how much a house is worth where the asking price is $1 MM or $1.5 MM can significantly change the answer even from the experts.

— People have marginal utility. A gain of $100 on top of $1000 is less valuable than a gain of $100 on top of $100. Even though rational economic behavior would assign the same value. This is visible in the effort people put in negotiating a home versus piece of used furniture.

So the first step is to shatter your own false image that you are always rational. The book is full of experiments, examples and  thought exercises, which will convince you.

Second step is to understand why this happens. Here Kahneman has introduced the concept of System 1 and System 2 brain. System 1 is reactive, fast reptilian part of the brain which works with quick retrieval, association, heuristics to come up with a quick answer. This is usually correct but sometimes dramatically wrong. And can be fooled with the biases we discussed.

System 2 is the contemplative, thoughtful and slower part of the brain which can apply rational checks and avoid the biases.

The book touches on some other parts of Kahneman’s research on experiencing self versus remembering self but I would not cover that here. Maybe he will write another detailed book on that.

Linking it to the life’s introspection, we must remain vigilant that our System 1 brain is not making a quick draw decision, when a more thoughtful response is needed. See things the way they are, not the way they appear!