How Daniel Kahneman’s research influenced financial advice

Nobel Prize-winning economist and psychologist Daniel Kahneman died on Wednesday at age 90. Kahneman was known for his pioneering research on decision-making and behavioural economics, with many of his findings applicable to the world of financial advice.

“As a financial planner, I have appreciated Daniel Kahneman’s insights that focus on understanding the psychology behind financial decisions,” said Zainab Williams, founder of Elleverity Wealth Management in Milton, Ont. “Behind every decision, there is a complex interplay of emotions and cognitive biases.”

“It would be impossible to overstate his importance and influence,” wrote John De Goey, portfolio manager with Designed Wealth Management, on X. “The entire premise of economics was overturned due to the work done by him and [frequent research collaborator] Amos Tversky.”

Historically, most economists believed people made decisions entirely rationally: by considering potential gains and losses, and weighing the probabilities of certain outcomes.

Kahneman’s research showed that “we’re quite bad at making decisions; we’re not always rational,” said John Waldron, founder of continuing education provider Learnedly. “People are going to make decisions that are influenced by how they feel and [try to] avoid ways that they don’t want to feel.”

“In a world inundated with choices, it’s crucial to recognize that our financial decisions are not purely analytical but deeply influenced by psychological triggers,” Williams said.

Waldron said Kahneman and Tversky’s research in this area was game-changing.

“One of [Kahneman’s] more significant contributions is around loss aversion, and the idea that the pain of loss is twice as great as the pleasure of gaining,” Waldron said. “We’ve always thought that if something goes up or down by the same amount, then you might be indifferent. But in reality, it’s not that way.”

Kahneman and Tversky investigated loss aversion in a seminal 1979 paper about what’s known as prospect theory. Per Columbia University, that paper is the most cited paper in economics and is among the most cited in psychological science.

De Goey suggested in an email that advisors should brush up on prospect theory in response to current market conditions.

“Most advisors and investors are not doing enough to mitigate the emotional pain they might feel if there was a protracted downturn,” he said. “There aren’t many products out there that allow for prospect theory to be properly addressed — which is why I have had to get a supplier to custom build inverse notes to address the very real risk that we all face, but that so few of us recognize.”

Waldron said one way to apply Kahneman’s research is to strike a balance between giving optimal advice that a client might be unwilling to implement, and giving seemingly suboptimal advice they’ll actually act upon.

For example, he said, concentrating fixed-income investments in a registered account and capital gains-earning investments in a non-registered account might be more tax-efficient than having two balanced accounts, but a client may be uncomfortable with the setup because the non-reg account appears too risky.

“You don’t want to set something up that might very well be optimal only for the client to then unwind it,” Waldron said.

Kahneman published the book Thinking, Fast and Slow in 2011, which became a New York Times bestseller and introduced his research to ordinary people.

Among many other concepts, the book popularized the idea of Systems 1 and 2. “System 1 is in charge of almost everything we do. Most of everything we do is skilled, and skilled activities are largely carried out effortlessly and automatically. That even includes routine conversation; it’s very low effort,” Kahneman told the American Psychological Association in 2012. “System 2 is slow and clunky but capable of performing complicated actions that System 1 cannot carry out.”

Complex arithmetic would be an example of System 2 thinking.

“Education influences System 2, and enables System 2 to pick up cues that ‘this is a situation where I’m likely to make those mistakes,'” Kahneman told the APA. Otherwise, a person tends to focus on whatever evidence is most available and ignore what isn’t.

The book also discussed Kahneman and Tversky’s concept of “the outside view,” which can counterbalance the “inside view” that is swayed by emotion and peers. The outside view is third-party, neutral data-driven evidence, while the inside view is more of a gut feeling and anecdotal, and may be what a person’s desires or emotions are telling them.

The work of Kahneman and Tversky, who died in 1996, is credited with inspiring the modern field of behavioural economics.

Kahneman won numerous awards for his research, including for his work with Tversky. These include the Nobel Prize in Economic Sciences (2002), the Lifetime Contribution Award of the American Psychological Association (2007), and the Presidential Medal of Freedom (2013).

Melissa Shin

Melissa is the editorial director of Advisor.ca and leads Newcom Media Inc.’s group of financial publications. She has been with the team since 2011 and been recognized by PMAC and CFA Society Toronto for her reporting. Reach her at mshin@newcom.ca. You may also call or text 416-847-8038 to provide a confidential tip.