The author Daniel Kahneman has an interesting background of being a Nobel laureate in the economy as a psychologist. His research studies how people make irrational decisions in uncertain circumstances. They had enough implications for the economy to earn a Nobel prize1. This book delightfully demonstrates a comprehensive view of his research. Out of many interesting findings, the Prospect theory is worth mentioning. Let’s think about the following two cases (add more 0’s to each $ if the value isn’t exciting enough):
- A: You received $1,000. Now, you have options of winning $1,000 more at a 50% chance, or winning $500 with a 100% guarantee.
- B: You received $2,000. However, you must choose between losing $1,000 at a 50% chance and $500 for sure.
Demonstrated this way, it is obvious that A and B are identical. However, when people were asked only one question, most preferred guaranteed $500 in A and a gamble of $1,000 in B. The only difference between these settings is a starting point: A from $1,000 and B from $2,000. As people are more sensitive to losses than gains, they take unreasonable risks2. Indeed, the book shows that the pain of losses is 2x larger than the joy of gains. This tendency has broad implications for society. People may continuously buy company stocks when they keep dropping. People are more frustrated when they get below average in a good company than above average in an incompetent one.
Human irrationality was a desired trait of natural selection. For example, losing your life once to a predator is irreversible, and no gain from successful hunting can compensate for that. Thus, we grew more sensitive to losses. This book shows many more interesting examples where humans naturally make irrational decisions. Those insights help us to make better decisions by showing how humans are designed to make undesirable judgments. ∎
More books to recommend:
- The Black Swan: The Impact of the Highly Improbable – Nassim Nicholas Taleb
- The Signal and the Noise: Why So Many Predictions Fail - But Some Don’t – Nate Silver
Daniel Kahneman Facts from the official web site of the Nobel prize ↩︎
This choice is irrational because of utilities. For example, if you had $1M, an additional $1,000 doesn’t provide much value compared to when you had only $100. So, the first $500 has higher utilities than the latter. This concept of utility can be applied broadly and is so reasonable that no one doubted it until Kahneman and his colleague Amos started to dig deeper. ↩︎