Thinking, Fast and Slow

by Daniel Kahneman

The premortem has two main advantages: it overcomes the groupthink that affects many teams once a decision appears to have been made,

it unleashes the imagination of knowledgeable individuals in a much-needed direction.

The main virtue of the premortem is that it legitimizes doubts. Furthermore, it encourages even supporters of the decision to search for possible threats that they had not considered earlier.

“The agent of economic theory is rational, selfish, and his tastes do not change.”

To a psychologist, it is self-evident that people are neither fully rational nor completely selfish, and that their tastes are anything but stable.

Our two disciplines seemed to be studying different species, which the behavioral economist Richard Thaler later dubbed Econs and Humans.

Unlike Econs, the Humans that psychologists know have a System 1. Their view of the world is limited by the information that is available at a given moment (WYSIATI), and therefore ...

What rules govern people’s choices between different simple gambles and between gambles and sure things?

The field had a theory, expected utility theory, which was the foundation of the rational-agent model and is to this day the most important theory in the social sciences. Expected utility theory was not intended as a psychological model; it was a logic of choice, based on elementary rules (axioms) of rationality. Consider this example:

Economists adopted expected utility theory in a dual role:

We were not trying to figure out the most rational or advantageous choice; we wanted to find the intuitive choice, the one that appeared immediately tempting.

During the first five years we spent looking at how people make decisions, we established a dozen facts about choices between risky options. Several of these facts were in flat contradiction to expected utility theory. Some had been observed before, a few were new. Then we constructed a theory that modified expected utility theory just enough to explain our collection of observations. That was prospect theory.

Fechner was obsessed with the relation of mind and matter.

On one side there is a physical quantity that can vary, such as the energy of a light, the frequency of a tone, or an amount of money.

On the other side there is a subjective experience of brightne...

Fechner’s project was to find the psychophysical laws that relate the subjective quantity in the observer’s mind to the objective quantity in the material world.

the function is logarithmic—which simply means that an increase of stimulus intensity by a given factor (say, times 1.5 or times 10) always yields the same increment on the psychological scale. If raising the energy of the sound from 10 to 100 units of physical energy increases psychological intensity by 4 units, then a further increase of stimulus intensity from 100 to 1,000 will also increase psychological intensity by 4 units.

In 1738, the Swiss scientist Daniel Bernoulli anticipated Fechner’s reasoning and applied it to the relationship between the psychological value or desirability of money (now called utility) and the actual amount of money.

He argued that a gift of 10 ducats has the same utility to someone who already has 100 ducats as a gift of 20 ducats to someone whose current wealth is 200 ducats.

economist Harry Markowitz, who would later earn the Nobel Prize for his work on finance, had proposed a theory in which utilities were attached to changes of wealth rather than to states of wealth.

The missing variable is the reference point, the earlier state relative to which gains and losses are evaluated.

In Bernoulli’s theory you need to know only the state of wealth to determine its utility, but in prospect theory you also need to know the reference state.

three cognitive features at the heart of prospect theory.

They should be seen as operating characteristics of System 1.

Many of the options we face in life are “mixed”: there is a risk of loss and an opportunity for gain, and we must decide whether to accept the gamble or reject it.

Although the expected value of the gamble is obviously positive, because you stand to gain more than you can lose, you probably dislike it—most people do. The rejection of this gamble is an act of System 2, but the critical inputs are emotional responses that are generated by System

For most people, the fear of losing $100 is more intense than the hope of gaining $150. We concluded from many such observations that “losses loom larger than gains” and that people are loss averse.

Professional risk takers in the financial markets are more tolerant of losses, probably because they do not respond emotionally to every fluctuation.

As you carried out this exercise, you probably found that your loss aversion coefficient tends to increase when the stakes rise, but not dramatically.

In this chapter I have made two claims, which some readers may view as contradictory:

In the bad case, the bending of the value curve (diminishing sensitivity) causes risk seeking. The pain of losing $900 is more than 90% of the pain of losing $1,000. These two insights are the essence of prospect theory.

In 2000, the behavioral economist Matthew Rabin finally proved mathematically that attempts to explain loss aversion by the utility of wealth are absurd and doomed to fail, and his proof attracted attention.

Rabin’s theorem shows that anyone who rejects a favorable gamble with small stakes is mathematically committed to a foolish level of risk aversion for some larger gamble.

He then shows that according to utility theory, an individual who rejects that gamble will also turn down the following gamble:

Monty Python sketch in which a frustrated customer attempts to return a dead parrot to a pet store. The customer uses a long series of phrases to describe the state of the bird, culminating in “this is an ex-parrot.”

Rabin and Thaler went on to say that “it is time for economists to recognize that expected utility is an ex-hypothesis.”

Furthermore, the failure of rationality that is built into prospect theory is often irrelevant to the predictions of economic theory, which work out with great precision in some situations and provide good approximations in many others.

Prospect theory has flaws of its own, and theory-induced blindness to these flaws has contributed to its acceptance as the main alternative to utility theory.

Prospect theory cannot cope with this fact, because it does not allow the value of an outcome (in this case, winning nothing) to change when it is highly unlikely, or when the

alternative is very valuable. In simple words, prospect theory cannot deal with disappointment.

Prospect theory and utility theory also fail to allow for regret. The two theories share the assumption that available options in a choice are evaluated separately and independently, and that the option with the highest value is selected.

Several economists and psychologists have proposed models of decision making that are based on the emotions of regret and disappointment.

The emotions of regret and disappointment are real, and decision makers surely anticipate these emotions when making their choices.

Prospect theory was accepted by many scholars not because it is “true” but because the concepts that it added to utility theory, notably the reference point and loss aversion, were worth the trouble; they yielded new predictions that turned out to be true.

We were lucky.

The convex shape indicates diminishing marginal utility: the more leisure you have, the less you care for an extra day of it, and each added day is worth less than the one before. Similarly, the more income you have, the less you care for an extra dollar, and the amount you are willing to give up for an extra day of leisure increases.

Few have noticed what is missing. Here again, the power and elegance of a theoretical model have blinded students and scholars to a serious deficiency.

By failing to display it, the theorists who draw this figure invite you to believe that the reference point does not matter, but by now you know that of course it does.

This is Bernoulli’s error all over again.

The omission of the reference point from the indifference map is a surprising case of theory-induced blindness, because we so often encounter cases in which the reference point obviously matters.