Delving into Daniel Kahneman: Top theories on decision making, rationality and bias

Nobel Prize winner Daniel Kahneman dies aged 90

Nobel prize winning psychologist and behavioural economics expert Daniel Kahneman died at the age of 90. Kahneman authored Thinking, Fast and Slow, a best-selling book that discussed his theories in behavioural economics.

Daniel Kahneman won the Nobel Memorial Prize in Economic Sciences in 2002 for integrating "insights from psychological research into economic science".

In his works, he attempted to debunk the belief that humans are rational beings who act out of self-interest. Instead, people's behaviour is rooted in their instincts or hard-wired mental bias.

His colleague at Princeton University, Professor Eldar Shafir said: “Many areas in social sciences simply have not been the same since he arrived on the scene. He will be greatly missed.”

Here's a look at some of the most important theories posited by Kahneman:

System 1 and 2

Kahneman proposed that the mind had two distinct operating systems. The first, System 1, represented all the effortless, fast and instinctive choices that we make. System 2, on the other hand, is representative of a more thoughtful, difficult decision making process. System 1 is more likely to fall prey to biases and overconfidence, while System 2 helps the mind delve into complex tasks that require deliberation.

Prospect Theory

The theory attempts to understand how people make decisions when presented with uncertain choices that could lead to a perceived gain or loss. Kahneman's theory says that people feel a greater emotional impact of a loss compared to a gain.

Therefore, when presented with a situation in which an investor could retain his wealth at status quo or risk losing it for a chance to increase it, human beings are likelier to choose the former. This theory is also known as the loss-aversion theory.

Also Read | 15 Daniel Kahneman essential quotes for decision-making, investing

Framing

From the second theory, psychologists have further expounded on the concept of 'framing'. There are two surface cleaners that are equally effective are available in the market: A and B. The tagline of Surface Cleaner A says 'Kills 99 percent of bacteria'. For Surface Cleaner B, the tagline is 'Only 1 percent of bacteria will survive'.

While the two products offer the same service, customers are more likely to purchase Surface Cleaner A since the two products 'framed' their claims in a different manner. A demonstrated its positive attribute - killing bacteria - while B represented its negative attribute - the number of bacteria that survive. This lends credence to Kahneman's "loss-aversion" theory, wherein humans do not like the prospect of loss.

Anchoring

Kahneman was one of the first psychologists to study anchoring. The concept of anchoring is simple: when presented with two pieces of information, humans are likely to base the new information on the first piece, thus treating it like an anchor or reference point.

If a man goes to buy a shirt, and he finds a shirt he really likes, but it's for $50, out of his budget of $30. However, he finds a second shirt for $40 which, while over his budget, is cheaper than the first option.

The anchoring bias can lead to logical and planning fallacies, causing systemic errors in judgement. This concept has been heavily utilized by brands and companies to promote discounts and sales.

Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.