Kahneman: Understanding Biases Can Improve Outcomes

This analyst blog is part of our coverage of the 2018 Morningstar Investment Conference.

Daniel Kahneman, Nobel laureate and author of Thinking, Fast and Slow, spoke with Sarah Newcomb, a senior behavioral scientist at Morningstar, at the 30th annual Morningstar Investment Conference in Chicago.

Newcomb and Kahneman agreed that in the private sector, and particularly in investing, research on behavioral biases can be used for good or evil, so to speak. In the worst case, these biases could be used to exploit clients. In the best case, they could help a client develop and implement their financial plan and potentially improve their outcome. In this vein, Newcomb asked Kahneman about some ways behavioral psychology can be used for good by advisors and investors alike.

The first step is to decide what's in the client's best interest, Kahneman said. Then the advisor needs to find some way to develop a "regret proof" policy--a policy someone can live with when things go badly. This reduces the chance that a client will capitulate at the wrong time and possibly move to another advisor.

Kahneman described a practice he had developed with colleagues to improve investor outcomes. First, the advisor would try to determine the client's loss aversion to create a measure of projected regret.

"We try to have people imagine various scenarios. We ask them, at what point do you think you would want to bail out?" There are some differences, Kahneman says, but he has found that even extremely wealthy people are loss-averse.

The next step of the solution they devised was to run client portfolios in two parts. One portfolio holds the assets the client is willing to risk, and the other is a much more conservative portfolio comprising what the client wants to protect. The portfolios are managed separately and clients get the reports individually.

This is helpful for clients because no matter the market environment, one of the portfolios is likely doing well. Of course, financially, it's one portfolio, but framing it as two separate accounts helps clients understand and tolerate the risks better, he explained.

Kahneman also touched on the role of the advisor as a therapist. Asset allocation, in many ways, is the easy part. Helping clients set reasonable goals and adhere to their plan is the difficult part; it requires having in-depth, sometimes personal conversations with client. One element of the process is broad framing, or taking a comprehensive look at the client's present and desired future outcome.

"Individuals tend to do very poorly guessing what stocks will do. Admitting you don't know is a very healthy step, but this admission leaves you with a great deal to do," he said. "You need to find out what the client's dreams are, what their fears are. And when bad things happen, you need to be there to help people stay on course."

Advisors should be realistic with investors about the potential outcomes, Kahneman said. They need to help clients make informed decisions. By discussing the risks in advance, you are helping to inoculate clients; you are preparing them for what could happen.

Newcomb asked Kahneman what problems he's researching currently.

"I've done a lot of work on biases or systematic errors that people make," he said. "But there is another important error, and that's unsystematic error. We call that noise."

He gave the example of a study conducted using pairs of insurance underwriters. Theoretically, their estimates should agree within 10%. If you look at the differences mathematically, though, they're much greater than that.

There is a lot more noise than people know, Kahneman said. In some of these cases, perhaps an algorithm would be better, because they are noise-free.

"I want people to be conscious of noise without sacrificing attention to bias," he said.