TIP053-daniel-kahneman

Executive Summary

 

This article provides an overview of Preston and Stig’s discussion of Daniel Kahneman’s book, Thinking Fast and Slow. If you want to read our executive summary of, this book, view this page instead. If you would like to download all of our book summaries, click here.
This article and podcast answers the following questions:

  • Will ECB expand quantitative easing?
  • What can the stock investor learn from Thinking, Fast and Slow?

Note: Before discussing the book, Thinking Fast and Slow, Preston and Stig started the podcast by talking about some of the current market conditions. The discussion started with Europe and whether the ECB could expand their quantitative easing program further.

Will the ECB expand quantitative easing?

At the beginning of 2015, the chairman of the FED, Mario Draghi, said that he was willing to “go beyond” the existing €1.1 Trillion quantitative easing program, which started earlier this year and is scheduled to end in September 2016. While he wasn’t specific about the details of ECB, he can increase the current $60B monthly buy back of bonds, change the composition, and extend the duration of the program.

Why is this happening right now, you ask? According to ECB, it’s because the European economy is still in a bad state, and is projected to grow only 1.4% in 2016. That, however, might only be one part of the story. Looking at the inflation rate in the Euro Zone, it’s as low as 0.2% and the Euro has gradually strengthened itself against the dollar. To the Europeans both factors are not good for sparking growth , and quantitative easing can at least, in the short run, weaken the euro and increase inflation. The optimist will say that now is the perfect time to use the instrument, but the pessimist will direct his attention to the growing bubble in bonds, and the unsustainability in the approach.

So, how should you react as a stock investor? The stock markets usually like quantitative easing. European stocks soared 1.8% the day Mario Draghi opened up for more quantitative easing. The reason is that as bonds are in a higher demand thereby decreasing the yield, it makes the stock in comparison more interesting. Preston and Stig, however, are not convinced that the relatively low yield on stocks – currently around 4% – is appealing just because the yield of bonds is closer to 0% than ever.

In the end, it really comes does to your style of investing. A billionaire like Warren Buffett doesn’t look at macroeconomic factors and consider it to be noise, whereas another billionaire Ray Dalio monitors the development meticulously. Both have been enormously successful with their approach.

What can the stock investor learn from Thinking, Fast and Slow?

Thinking, Fast and Slow is written by Nobel Prize winner in economics, Daniel Kahneman. The core of the book is about how our brain consistently makes systematic mistakes. One of the most important concepts is “anchoring”. To understand the concept, consider the following study that Kahneman did: After letting the participants in the study spin a roulette wheel, he asked them: “How many African countries are there?” It turned out that the higher the number of the ball that landed on the roulette wheel, the more African countries the participant estimated. The example shows how a complete random number can distort our perception of something most people have little knowledge about.

Let’s take the example one step further. Kahneman also asked how old the participants thought Gandhi was when he died, and included a high or low age as a reference. Specifically they were asked whether Mahatma Gandhi died before or after he was 9, or before or after he was 140 years old. Clearly, neither of these anchors can be correct, but the two groups still guessed significantly differently (average age of 50 vs. average age of 67). This is because the participants anchored their estimate based on the question.

As silly as the examples of estimating the number of African countries and the age of Mahatma Gandhi when he died (which was age 78) may seem, what is interesting is that the same thing happens in the stock market. If you buy a stock at $10, you would intuitively consider it to be an “average price”. That is the price that determines if you can sell your stock as a loss or at a gain. This makes you more likely to sell your stock when it reached $12 before you can lock in that specific stock as a gain, and make you less likely to sell your stock if it drops to $8.To most people, a stock that drops to $8 is not perceived to be at a loss because it’s not sold. Data shows that because of this systematic behavior, investors typically hold on to bad stocks for too long, and don’t hold on to the good stocks.

What you as a stock investor can learn from Thinking, Fast and Slow, is that you should be blind to your price of the stock once it’s already purchased, and solely focus on the value of the stock. Now, the price is still important. If you see that the price is significantly higher or lower than the value you currently estimate, you might respectively sell or buy more of the stock, but what you specifically paid should not be an anchor for you.

Books and resources mentioned in this episode

Daniel Kahneman’s book, Thinking, Fast and Slow – Read reviews of this book.

Nassim Taleb’s book, The Black Swan – Read reviews of this book.

Robert Cialdini’s book, Influence – Read reviews of this book.

Stig’s blog post, Why Mutual Funds can’t Beat the Market

Videos that Support this Podcast

Thinking Fast and Slow


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