Editor’s note: This article was first published in January 2013; its opening worries, the European banking crisis, the US fiscal cliff, falling US GDP and China’s slowdown, are those of that moment. Daniel Kahneman is described in the present tense, but he died in March 2024.
Are we worried about the European banking crisis, the US fiscal cliff, the drop in US GDP, China’s slowdown…? Nobel Prize-winning psychologist Daniel Kahneman, author of Thinking, Fast and Slow, believes we need to stop, reflect and realize that these short-term worries are seriously undermining our ability to think rationally as investors.
Kahneman studies how human beings are strongly predisposed to make the wrong decisions most of the time, and this happens especially often among individual investors. According to Kahneman, the main problem is our belief in a false ability to predict the future, or, for that matter, to explain the past accurately. We tend to look for a reason why the index fell today, and there isn’t always a logical or rational one.
Finding that reason today gets in the way of our ability to analyze things sensibly tomorrow and to think clearly about the long term.
We tend to think above all about short-term results. We focus too much on recent experience, which we assume will continue. This mistake makes investors (professionals included) overly risk-averse when stock markets have fallen, and overly optimistic when markets have risen. This is what leads individual investors to buy at the top, especially those who invest on the advice of professionals (professionals who don’t beat the market either).
This is how Kahneman explains why, over long periods, only a very small percentage of fund managers manage to beat stock market index returns after fees. He concludes that the investment industry is built “on an illusion of skill”.
Kahneman maintains that active investing is simply a losers’ game in the stock market, because everyone thinks they can beat the market by making lots of daily or monthly trades. He reminds us that over the last 50 years, the only investors who have beaten the market are the old-school ones, especially those who use Benjamin Graham’s investment method as set out in The Intelligent Investor.
These days people say Graham’s method doesn’t work anymore, and new investment methods keep appearing that claim to beat the market. But the only ones who keep beating the market are the same ones who did it 50 years ago, among them Warren Buffett and George Soros. Making money in a bull market (where everyone makes money) doesn’t turn some investors into “investment geniuses”, just as sitting on losses in a bear market doesn’t make you an idiot.
The key is being able to spot other people’s irrational behavior and to minimize the chance that your own conduct falls prey to the same biases. In the stock market, far from the new miracle methods, what still works is “long-term investment in a company with growth potential”. Everything else is noise and distraction that, in the long run, costs us money or earns us lower returns. And Kahneman insists that 50 years of comparing investment methods prove Graham’s method right: a method inherited by Buffett that nobody has managed to beat in returns to this day, whatever anyone says.
My personal opinion: I think Kahneman makes it pretty clear, and his explanation seems impossible to refute (the numbers speak for themselves), so there’s not much more to say 🙂
Further reading
- The best investors in history and their annual returns
- The 10 favorite stocks of the great investors
- The most profitable investments for reaching financial freedom
Featured image: Buster Benson, CC BY-SA 2.0, via Flickr.
