Would I recommend Thinking, Fast and Slow by Daniel Kahneman? It’s a very interesting book on how our thinking works and it can open up your mind about your own behaviour. But I mind you, only start reading it if you read a lot and you don’t rush to start another book anytime soon.
I find it very difficult to put down books. If something is really bad, I might put it down. But if I find something interesting even if it doesn’t match exactly what I was looking for, I’ll likely keep on reading.
This book didn’t exactly match what I was looking for, but it’s definitely a very good book, so I kept on reading.
Let me share a few words on the author and the main idea behind this book.
Daniel Kahneman is a psychologist and economist who researched extensively the psychology of judgement and how people make decisions. These led him to behavioural economics. His work on this subject was rewarded with the Nobel Prize in Economic Sciences.
He often referred to Amos Tversky in his book. Tversky is another psychologist who he worked a lot and became friends with. They studied a lot about how we - humans - make errors from our heuristics and biases. As a result, they developed prospect theory. Now let’s discuss a couple of the ideas presented in Thinking, Fast and Slow.
The two systems
First and foremost, there are no two distinct physical systems in our brains, this is a simplification. It’s an abstraction of how the brain works. If we examine how we think, how we react, we can recognize two patterns, two distinct systems.
System 1 is about reacting quickly. It’s automatic, we could say intuitive. It serves our basic human body functions, it helps us stay alive in a dangerous world. It helps us avoid losses, it’s responsible for our fears.
System 2 is slower. It’s not automatic, it’s rather analytic. If something is not in our instincts, if we do something that requires conscious thinking, like calculating 17 * 24, system 2 is involved.
There is no right or wrong system. Both are needed, both are important and both can make mistakes. Things become overly interesting when these systems are interacting with each other and when their predictions or decisions are in conflict.
Prospect theory
Human beings are quite loss averse. Our fear of losing something is much bigger than our joy would be if we won the same thing. Though the exact numbers vary, we should be promised to win 3-7x more money than we could lose.
Let’s say you have these two options:
- 100% chance to gain $450 or 50% chance to gain $1000
- 100% chance to lose $500 or 50% chance to lose $1100
In the first scenario, most people will take the guaranteed win. Although we could make the double with a 50% chance and its future value (0.5*1000 = 500) is higher than the guaranteed 450, most people will not take on the risk.
On the other hand, when are facing a situation where we’d lose anyway, most of us we’ll take some risks to avoid the greater loss. Even if it’s against the odds. Despite the fact that 0.5*1100 (550) is a higher loss than 500, we are so much loss-averse that we’ll take on the risk.
The utility theory would advise otherwise, but we are emotional creatures. We cannot simply maximize the wins and minimize the losses.
We are not so rational.
Our rationality is cheating on us in another way too. We tend to attribute excessive weight to events with low probabilities and insufficient weight to events with high probabilities. We may unconsciously treat an outcome with a probability of 99% as if its probability were 95%, and an outcome with a probability of 1% as if it had a probability of 5%. In other words, we’d often be paralyzed by a tiny chance of failure.
The Endowment Effect
I’m sure you experienced the endowment effect in your own life. It says that you are more likely to retain something that you already own than acquire the same object if you don’t own it yet. It’s very simple to get an example. Imagine your favourite sweater. You’d probably not give it away for the same amount of money that you’d be happy to pay for a new one if you lost it.
Of course, the authors conducted some more interesting experiments. Let’s say you have a ticket to a major sports event. You got the ticket for the nominal price. Then the prices go up and you have a chance to sell the ticket for 3x price. There is a fair chance that you’d not sell it, it’s already yours and you want to go. Even though, economically it’d make sense to make the extra profit. At the same time, you’d not buy the ticket for the 3x price. Does it make sense? According to the endowment effect, it does…
Another experiment was performed with a wine-lower person. He was not willing to buy wine above $35 (in 1975!), but he was also very reluctant to sell below $100. There was nothing in between. Economically it would have made sense for him to buy a bottle of wine worth $50 for him for a price of up to $50 and sell it for anything more. But he didn’t do so. There was this huge gap between the maximum buying price and the minimum selling price.
That’s the Endowment Effect in action.
Conclusion
If you are interested in both psychology and economics, Thinking, Fast and Slow by Daniel Kahneman is a must-read. If you have plenty of time! It’s going to be long. But if you can dedicate the time, you can learn about the above phenomena in detail and much more. I have no regrets about reading it.
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