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Michael Lewis and Daniel Kahneman

The Sunday Times magazine carried an article this week about two people whose work I enjoy hugely – Daniel Kahneman and Michael Lewis. More specifically it was an interview with Michael Lewis, author of Liar’s Poker, Moneyball and the Big Short amongst others, who has written his latest book about Kahneman and his former co-author Amos Tversky and how the two men came together as friends and then radically changed the way we think about the human mind and why we make the decisions we do. Before their work, economists mostly thought of people as generally rational beings who would analyse all the necessary information before coming to the best decision.

Starting in the 1970s Kahneman and Tversky’s theories demolished this and showed how humans make vast numbers of irrational and overconfident decisions based on in built biases that are factually incorrect or hugely distorted by self-deception that often comes from our attempts  to understand a complicated and unpredictable world by over simplifying it with mental short cuts. “The world is so much more uncertain than our minds can tolerate,” says Lewis. “It drives you crazy if you really think about it. So we have these mechanisms that make it seem more knowable than it really is.”

The work of Kahneman and Tversky laid the foundation for the field of behavioural economics, which takes these irrationalities into account when making economic decisions. The article also highlights something that I had not known previously. That rather than being a couple of academics pondering away in their ivory towers, Kahneman and Tversky had actually applied their ideas to the most testing of real world situations – warfare – and even returned to Israel during the Yom Kippur War and practised behavioural economics and psychology under fire in a war zone by devising a new system to feed troops more efficiently based on testing what was thrown away by troops to see what was not being eaten. Kahneman also devised a still used system for the Israeli military to ensure soldiers are given the most appropriate duties and sent to the units where they would perform best. This removed the previous “gut feel” approach, reliant on intuition, which had been found to be ”almost useless for predicting the future success of recruits.” Instead interviews were limited to a series of factual questions scored on six personality traits and it was so effective that it has been used for decades.

As Lewis notes in the interview, “They’re academics continually thrust into the world. It occurred to me when I was writing this new book how much better off we would all be if, every five years, all professors had to go shoot and be shot at. It would energise their work and connect it up to real life in so many different ways.”

One of Lewis’ trademarks has been taking complicated and ostensibly impenetrable subjects and turning them into compelling page turners. This often comes by finding smart guys who think differently to the masses and letting us into their minds so we understand and appreciate their position. I will certainly be asking for a copy of this latest volume on my Christmas list – “The Undoing Project: A Friendship that Changed the World”!

To finish off by connecting this with the world of investment, when we build portfolios here at MASECO we look to remove as much of the emotion and in built human “heuristic” biases as we can from decisions as it is this that we feel, in common with Kahneman and Tversky, that pollutes the decision making of many investors together with over-confidence and the illusion of their own skill in picking individual securities. Instead we focus on the expected returns from markets and risk premia that have been evidenced by decades of academic research and empirical experience. To reflect this we call them “Rational Portfolios”.


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