In 2011, on one of the dusky evenings at the premises of the lush green campus of the University of Hyderabad, I joined my peers for evening coffee at the “GOPS”. This has been a favorite hub of young students and researchers to meet and converse. There has been great learning from these thought-provoking and nerve-breaking discussions which range from history to contemporary policies. While I was researching on stock returns-inflation nexus, our discussion led us to question whether individuals and institutions rationally think of such a proposition when they invest in markets or whether our economic decisions are based on mainstream economic assumptions. This discussion led me to visit a bookshop near ShopCom, another favorite spot of students, where I came across “Thinking Fast and Slow” by Daniel Kahneman, which was launched at that time.
The book left an indelible impression on me. I was astonished and dazzled by the insights of this book that the sentiment of the investors drives markets. The psychological heuristics and biases have a remarkable role to play in it. Since then, I have become a religious follower of the writings of Daniel Kahneman. I was inspired to read and understand the significant role of behavioral aspects of investors in the asset price divergence in the markets. That led me into my PhD dissertation which documents the role of irrational investor sentiment in asset price dynamics. Kahneman remains always close to my heart as an academic because of his legendary contributions to the field of economics and finance and his legacies are worth remembering.
Here, I will narrate how his invincible and memorable journey remains a great memoir to the field of economics and finance. The disruptive thoughts of Kahneman brought a paradigm shift to the conventional thought process of finance. Kahneman incepted integral psychological aspects in human judgment in the most logical way. Kahneman’s contributions are astronomical and will always be remembered as remarkable achievements to academics, investors, and fund managers.
Kahneman introduced new connotations to the field of behavioral economics and finance such as the perception, representativeness, endowment effect, flaws in human judgments, emotions, cognitive limitations, system I and system II in decision making, noise, over-confidence, irrationality, and several other cognitive heuristics and biases which plays integral role in human judgment and irrational decision making., The “Prospect Theory” and its values functions and the reference point in utility maximization brought a phenomenal shift in understanding utility maximization and the risk and returns relationships in economics and specifically to the financial markets.
In the background, the conventional economic approach stands by the utility maximization principle. The rationality principle is the cornerstone of the conventional approach. According to rationality, risk-averse individuals receive new information, and they update their beliefs correctly, in the manner described. Secondly, given the investors’ beliefs, agents make normatively acceptable choices, in the sense that they are consistent with Savage’s notion of Subjective Expected Utility (SEU).
In contrast, the theoretical aspects of prospect theory by Kahneman, postulate that investors are not always risk-averse rather investors can be risk-seeking by nature. Prospect theory is the mathematical explanation of the utility function being concave when investors are risk-averse and convex to the origin when investors are risk-seeking in nature. Prospect theory highlights that any financial investment analysis or utility evaluation is relative to the past reference point (adaptation level). Secondly, the principle of diminishing sensitivity applies to both concave and convex dimensions as there is a change in wealth. Thirdly, Kahneman was the first to highlight that losses loom larger than gains (individuals weigh losses about twice as much as gains) and brought a new concept of loss aversion in contrast to the subjective utility theory.
The study on loss aversion reveals that investors’ choice depends on the probability of certainty. They show that individuals and investors will always choose certain gains over uncertain gains and vice-versa. The further contribution of prospect theory is the “disposition effect” which is the consequence of the loss-averse attitude of the individuals.
The essence of the disposition effect states that Investors in financial markets sell the winners due to a risk-averse attitude and hold the looser assets too long due to the risk-seeking attitude which is an inherent psychological bias. Prospect theory predicts that investors sell winners and hold losers in the hope that the price will converge back and avoid realizing a paper loss.
Unlike the conventional utility function, the principles mentioned above govern the value function outcomes. With the implementation of the prospect theory and its governing principles into behavioral economics and essentially to the financial markets, the interpretations of utility and risk and returns trade-off changed to the core. Prospect theory highlights that investors are not only risk averse but also loss averse. At the contemporary phenomena, we can ponder that investors are no more rational in decision making and human judgments always suffer from judgment flaws. Essentially, individuals give more emphasis to loss-making in the financial markets which were earlier neither pertinent nor prevalent. Kahneman a psychologist brought emotions into the economic rational decisions and relaxed the assumption of rationality and risk-aversion.
Furthermore, Kahneman in one of his other Nobel contributions to behavioral finance “Noise” a flaw in human judgment intuitively states how noise leads to errors and variability in judgment in all fields including economic utility maximization, economic forecasting, and financial markets buy and sell decisions. Noise intuitively elaborates on how and why humans are so susceptible to non-fundamental factors and biases in decision-making. Essentially, Kahneman, Sibony, and Cass Sunstein focused on how psychological biases distort rational decision-making. Build upon the psychological mechanisms that explain the marvels and flaws of rational intuitive thinking.
In Noise, Kahneman elaborates that the manifestation of different heuristics such as representativeness, sample size neglect, anchoring, availability, and affect and biases such as excessive optimism or pessimism, overconfidence bias, confirmation bias, and belief perseverance create variability in rational human judgment. These heuristics and biases create noise trading (trading on non-fundamentals) which remains ubiquitous to financial market decisions.
He further highlights that the implementation of psychological and cognitive biases creates cognitive abilities and limitations of humans to formulate decisions that are bounded by time limits and asymmetric information available in the markets. Henceforth, the individual’s and investor’s decision-making becomes irrational when they do not trade on market fundamentals. This as a result creates asset price divergence and a higher level of volatility in the financial markets. These volatile markets create stochastic anticipated market returns and sometimes substantial losses make investors astray.
The plethora of studies in the past three decades shows that market total variance (total risk) decomposed into systematic and unsystematic risk cannot make markets stable and efficient. Instead, markets remain volatile. According to Kahneman, the markets are governed by psychological principles and produce statistical biases in the findings and noise in the markets. He embodied the role of cognitive psychology in the field of economics and finance. His new insights on human judgment and decision-making were applied to real-world practice.
The intuition of noise to the financial markets contributed from the psychological factors are truly remarkable and provide different avenues to analyze the financial markets and economic decisions. Noise precisely highlights that rational risk-averse arbitrageurs in the markets are non-existent. The essence of “Noise” states that human judgments are always biased and conditional upon availability.
Kahneman instills the role of psychology in terms of system I judgment (mental shortcuts and immediate impressions), a fast-thinking approach that is intuitive and emotional decision-making for humans. His lifetime research is prominently known for debunking the subjective notion of utility in economics and wealth maximization in finance. Kahneman argued through his lifetime research that investors can never be rational as judgments are conditional such as investors being overconfident, prone to their past representation, prone to recent events (recency impact), optimism and pessimism, etc. For instance, investors suffering from recent substantial losses would be reluctant to invest immediately in the financial markets as the shock intuition is fresh in his mind although the market conditions are conducive and fundamentals are strong. Hence, Daniel Kahneman upended the psychological factors and corroborated that financial markets’ plausible phenomena are well explained when investors are irrational and trade on noisy signals. Kahneman’s legendary contributions will steer the further deeper understanding of the individuals, investors, and fund manager’s behavior in financial markets decision-making. We will always remember him as a legendary hero with his insurmountable contributions to the field of economics and finance.