WASHINGTON, Feb. 12 (UPI) — Optimism to the point of delusion is the key force driving financial markets, said Daniel Kahneman, last year’s recipient of the Nobel Prize in economics.
“How else can you explain … why you think you could beat the markets, better than anyone else?” he asked alumni of Princeton University’s MBA program in a presentation late Tuesday.
The Israeli-born laureate is a professor of psychology at Princeton, and he won the prize for his studies on behavioral economics, by integrating psychological research into economic science. Specifically, his studies focused on how human judgment might take shortcuts that systematically depart from basic principles of probability.
One reason that rationality flies out the door and individuals take high stakes in financial markets despite the odds is due to an exaggeration of one’s skills, Kahneman said. For example, most people think that they are good drivers — yet, if the vast majority were as skillful as they claimed to be, there would be far fewer car accidents, he noted.
Another reason for optimism about financial gains is the “illusion of control … which is the most damaging,” he said.
Specifically, he noted that while ability can get people far, much is actually dependent on chance and opportunity, both of which are out of anyone’s control.
“Massive overconfidence underestimates the element of uncertainty,” he said.
On the other hand, individuals tend to be thrown off by the way risks are posed to them, as they are willing to take on some bets but not others depending on how they are presented.
For instance, Kahneman said, people might eat 90 percent fat-free cookies but not cookies that are labeled as containing 10 percent fat, though both labels refer to the same product.
Similarly, he said, investors might be unwilling to take on a bet that states there is a 50 percent chance of winning $15,000, with a 50 percent possibility of losing $10,000.
But they might be more willing to take the risk if they were offered a 50 percent chance of gaining $15,000 in addition to their usual income, and a 50 percent probability of losing $10,000 from their income, though both proposals mean the same thing.
As such, decisions might be swayed by the manner in which risks are framed, Kahneman said. He added that investors tended to take decisions one small issue at a time, which was not the most conducive to making profit. Moreover, he pointed out that when investors had a mixed portfolio of winning and losing stocks, they tended to sell off the winners, which often subsequently gain in value.
“These findings are really depressing,” said one MBA alumni attending the lecture.
But interestingly enough, optimism is often a reflection of an individual’s cultural background more than other factors such as gender and income level.
“Americans are the most optimistic people in the world,” Kahneman said, adding that U.S. society broadly encourages and rewards optimism, while pessimism is “seen as a sign of weakness.”
“But in other cultures, Europe in particular … optimists can be seen as simply being naive,” Kahneman said. Moreover, the two sectors that are especially dominated by “huge optimists” are the financial sector and the military, Kahneman said.
“Military generals, by their very nature, have to be very optimistic,” he said. Yet he pointed out that generals on two warring sides “cannot both be right, expecting victory,” as one side must lose in order for the other to claim victory.
“And that optimism is alarming,” he added.