Daniel Kahneman, the Eugene Higgins Professor of Psychology at Princeton University and Professor of Public Affairs at Princeton's Woodrow Wilson School, delivered the annual George H. Leatherbee Lecture at HBS on March 6, 2000. The Leatherbee Lecture, a series of scholarly programs addressing issues of finance and business, was established in honor of George H. Leatherbee in the early part of the twentieth century. HBS Working Knowledge's Martha Lagace reports.
"The human mind is a pattern-seeking device," says psychologist Daniel Kahneman.
And the patterns that the mind seeks, he adds, may swing in two opposing directions, almost as mirror images of each other.
On the one hand, says Kahneman, people have a great tendency to overestimate their own skills, whether that means their driving ability, sense of humor, or even talents as an investor trying to beat the market. Such undue optimism — by applying overly favorable odds to events over which we have little or no control — leads to what he terms "bold forecasts."
The flip side, Kahneman has discovered, is that people also go through what he labels overwhelming "loss aversion" when confronted with a decision that has been framed in a particular light. They would rather err on the side of unreasonable caution, he posits, than cope with a possible loss. They may ignore the big picture, and the result is a timid decision that can lead to mistakes just as surely as optimism can.
Kahneman, whose work has broad implications for executives and investors, recently presented his views in depth to the Harvard Business School community at the Leatherbee Lecture, in a talk entitled "Risk Taking: A Tale of Two Biases."
"Executives think they're in the business of navigating in stormy waters," Kahneman told the HBS audience. "They think they can continue to apply skills and that they do not relinquish control."
An Engine of Capitalism?
To illustrate the notion that people automatically magnify their own skills,
Kahneman described some of his studies which queried people about how they
thought their driving skills — as well as sense of humor — compare to those of
other people.
"About 90 percent put themselves above the medium," he said. Organizations no less than individual entrepreneurs, according to Kahneman, may deny uncontrollable risks. "Optimism in our culture is a highly valued trait," he said. "So pessimism is viewed as a sort of disloyalty. All this creates a kind of rhetorical asymmetry favoring optimism."
Referring to Alan Greenspan's famous remark about the "irrational exuberance" of the market, Kahneman said that the financial markets are a classic case of an activity that refuses to distinguish the particular from the general. "Investors think, ‘No one can beat the market — but I can,'" he said. "People in that business believe that the markets are almost perfect — not perfect enough for others, but perfect enough for them."
"Is denial of odds an engine of capitalism?" he asked rhetorically.
The benefits and costs of optimism are clear, he said. Bold forecasts reduce the pain of risk-taking, and optimism is, naturally, helpful in the execution of plans, building high morale, and instilling a sense of perseverance and resilience in everyone it touches. "In some sense this makes the game a better game," he said.
On the downside, though, he said, optimism can also lead to highly unrealistic expectations. Referring to research by HBS Senior Research Fellow Max Bazerman, about the behavior of participants in a "final arbitration" scenario, Kahneman said the research concluded that participants wildly overestimated the probability that their opponent would accept their "last" offer.
"This is pernicious," Kahneman told the audience. "Because that kind of optimism about what someone will think about my offer means that the offers are even further apart [than they are].
"This is what happens in wars," he asserted. "Wars must involve some optimistic generals because they think they will win this thing. But if you think you are going to lose, there are other courses of action than fighting."
The Scourge of Timid Decisions
Running in tandem with the tendency to make bold forecasts, Kahneman
observed, is an equally natural tendency to form timid decisions. Timid
decisions come about, he suggested, because we frame our dilemmas very narrowly,
by calculating what we stand to lose rather than the overall "wealth"
that might be achieved.
With loss aversion, people go to absurd lengths to avoid risks that are actually negligible. They can't see the present situation as part of a broader class; they should think about what the best tack should be for the broader class, he said, rather than for the particular decision at hand.
"If you consider gambles not in isolation but in aggregation, you are probably much closer to risk neutrality and would be richer in the long run," he said.
As for correcting these two opposing biases, Kahneman said, it is not a good idea for individuals to focus on correcting one without doing something about the other.
The Mood of the Market
"Is capitalism profoundly irrational?" Kahneman was asked by a
member of the HBS audience.
"Some stupid ideas turn out to be excellent ideas after the fact," he replied. "Exaggerated optimism and faith in success of your particular dot.com is probably a public good, in some sense. It seems to me entirely possible that capitalism will thrive when there is a lot of optimism: This exaggerated faith in our ability to control things is a contribution to prosperity."
A fundamental issue at stake in controlling the process of bold forecasts and timid decisions, Kahneman said, is to clearly distinguish the separation between games of skill and games of chance.
"Entrepreneurs hate the gambling metaphor," he said. "Certainly there is some control involved [in the market], and things would be worse if there weren't some control. What is very striking about the psychology of financial bubbles is that investors think they'll get out in time and other people won't. This notion is quite common.
"But," he added, "I think there is very little correlation between optimism and actual success."
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Life Lessons in Optimism Psychologist Daniel Kahneman, in his lecture at HBS, illustrated the dangers of being too optimistic in one's decision-making by telling the audience of a true example from his own career. Many years ago, he said, he was teaching at the Hebrew University in Jerusalem. He and a group of colleagues decided to prepare a curriculum, along with a book, to teach judgement and decision making to high school students. "We had support from the Ministry of Education, a constructive theme, and good people on our team, including teachers and writers," he said. "After a year, we had an outline for the book we were going to write, as well as sample lessons. It was moving along." On one particular Friday morning, Kahneman said, he decided to ask the team how long they all expected it would take to complete the project. "We had not asked ourselves that question before," he said. "There was one thing I knew: You're better asking people to write their best guess on a slip of paper, which is what we did. And there was very little variance among the answers: Everyone estimated that the project would take between 1-1/2 and 2-1/2 years. "But then I had another idea," he said. "I decided to ask the Dean the following questions, since we weren't the first group in the world to develop a curriculum where none existed before. So I asked him, 'Can you assess where previous groups were when they had accomplished what we have accomplished thus far?' and 'How long did it take them to complete their assignment?' "He thought for a while. 'You know,' the Dean replied, 'they didn't all write a book. And 40 percent of them never finished.' "'And of those who did finish, how long did it take?' I continued. "'I can't think of any that took less than seven years,' the Dean answered. '"So between seven and ten.' "'What,' I asked, 'is the distribution of outcomes in cases that resemble ours? How do our resources compare to those of other groups?' "'Below average,' the Dean said, 'but not by much.'" Kahneman was faced with an unwelcome predicament, although it also presented him with two different ways of looking at a forecast problem. The "inside plan" of Kahneman and his colleagues, who had only been focused on their own specific situation, had anticipated that their project would take a fairly short time to complete. In their minds, their plan was already set, or "anchored"; now, they reckoned, all they had to do was adjust for contingencies of the plan. At the same time, however, as Kahneman explained to the HBS group, the Dean's "outside view" took in the whole universe of consequences. "One of these views is far more trustworthy than the other," he told the audience. "We should have quit. Obviously! None of us was willing to take a 40 percent chance of failure. This was the end of rational planning for that group. What happened is that there were quarrels, divorces — that's the way things take seven years. "The book was actually completed eight years later," he said. "Nobody ever read it; it was a complete failure." |
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