Kahneman: Clients Driven by Losses, Not Gains

In an address that was part social science, part high-end psychology and part homespun advice, with lessons from the “idiotic call” at the end of Super Bowl XLIX, Daniel Kahneman gave behavioral finance advice directly to advisors on Tuesday on day two of the IMCA New York Consultants Conference. 

Kahneman, a psychologist who won the Nobel Prize in economics and recently published “Thinking Fast and Slow,” began by speaking about loss aversion: that human beings feel and fear loss much more than they enjoy gain.

Saying that “your grandmother knew it and so did mine,” the Princeton professor said “your clients are more sensitive to loss than gain,” that they can be “infinitely loss averse when ruin” is one of the possible outcomes and that when it comes to wealth preservation, “people aren’t concerned about their level of wealth, but about changes in their wealth.”

To illustrate a related loss aversion principle known as the endowment effect, Kahneman related the findings of a famous experiment he and behavioral economist Richard Thaler conducted with coffee mugs and two groups of people. One group was given mugs and the others were given a sum of money: the mug owners, it turned out, demanded an average of $7 to sell their recently acquired mugs to the moneyed group; but the mug-less group was only willing to pay an average of $3 to buy the same mug.

As Thaler defined it, the endowment effect found that “people often demand much more to give up an object than they would be willing to pay to acquire it.” When working with clients on investing, Kahneman suggested that advisors recall this effect, that “people don’t like giving up things” even when they’ve only owned those things for a short time, like stocks in a portfolio.

He then turned to the concept of hindsight, in which “an event seems predictable after the fact.”

His example came from Super Bowl XLIX. “Look at the amount of credit the Patriots got after that stupid play” in which the Seahawks attempted a goal-line pass that was intercepted. “If the Seahawks had won, everything  would have been different,” with commentators praising the Seahawk players. As it was, however, “everyone should have known, after the fact, that the Patriots were the stronger team.”

Much of life comes down to luck, Kahnemann preached: While the Patriots had “no control over the Seahawks’ idiotic call,” the winning Patriots after the fact felt they deserved to win. Since “the world is not predictable, a lot of what happens is luck. We greatly underestimate the role of luck; we overestimate the management” of good firms.

“Hindsight induces us to believe we understand the world because we understand the past,” which is a particularly dangerous belief for advisors to exhibit.

“Advisors will get blamed” by their clients for “not knowing what will happen,” he said, despite the fact that the future is unknowable.

While many observers claimed they saw the financial crisis coming, there’s a big difference between “thinking” and “knowing” an event will happen. All too often, he said, the people who predict events, especially in the markets, are writing in “invisible ink”; only later will they say such predictions are “written on the wall” for all to see.

Returning to how clients feel, Kahneman warned of the “emotion of regret,” saying that clients will “feel the pain acutely” of lost investment opportunities and then will, regrettably, seek to act on that regret. He suggested that’s why so many investors, having seen an investment rise in value, will seek to buy that investment after it’s had its run. It’s also why, as research has shown, that mutual fund investors will rarely profit from the increase in a fund’s value, since the investors will far too often buy into and get out of funds, to their detriment.

“Try to prevent people from acting out of regret,” he counseled advisors, and look at the discussion of regret with clients as a “form of vaccination.” In fact, he suggested that advisors should build different portfolios for clients prone to regret, because they are also more prone to “changing their mind at the wrong time.”