Daniel Kahneman: The Thought Leader InterviewBy Michael SchrageThe Nobel Prize–winning economist parses the roles of emotion, cognition, and perception inthe understanding of business risk.A bat and a ball cost $1.10 in total. The bat costs $1 more than the ball. Howmuch does the ball cost?Almost everyone feels the temptation to answer “10 cents” because the sum$1.10 so neatly separates into $1 and 10 cents, and 10 cents seems the rightprice for a ball (small and light) relative to a bat (big and heavy). In fact, morethan half of a group of students at Princeton and at the University of Michigangave precisely that answer — that wrong answer.The right answer is: The ball costs a nickel.“Clearly, these respondents offered their responses without first checking,”observes Daniel Kahneman, the Eugene Higgins Professor of Psychology anda professor of public affairs in the Woodrow Wilson School of Public andInternational Affairs at Princeton University, and the winner of the 2002 NobelMemorial Prize in Economics. “People are not accustomed to thinking hard andare often content to trust a plausible judgment that comes quickly to mind.”You might choose to dismiss the baseball query as a trick question. But thepathological mistakes and the persistent miscalculations smart people makewhen they’re making up their minds is at thecore of Professor Kahneman’s path-breaking research. With his late collaborator Amos Tversky of Stanford University,Professor Kahneman completely reframed how economics and finance define and measure rational behavior. Theirprovocative thinking about thinking and simple — yet remarkably powerful — experiments have revealed the quirks,logical inconsistencies, and flaws in human decision making that represent the rule rather than the exception incognitive processing.Prospect Theory — the researchers’ empirical exploration of risk assessment, loss aversion, and referencedependence — explains why individuals consistently behave in ways that traditional economic theory, predicated onthe optimization of individual self-interest, would not predict. This work directly spawned the controversial and excitingfield of behavioral finance. Championed by economists such as the University of Chicago’s Richard Thaler and Yale’sRobert Shiller, author of Irrational Exuberance (Princeton University Press, 2000), behavioral finance defies therational investor/random walk algorithms of market analysis in favor of models of judgment under uncertainty.Research undertaken decades ago by Professor Kahneman, Professor Tversky, and their intellectual allies nowinfluences hundreds of billions of dollars put into corporate investments worldwide. Their insights into the nature ofhuman judgment have prompted fundamental reevaluation of how individuals spend their time, their money, and theirthought. It’s hard for an intellectually honest person to read a paper by Professor Kahneman without feeling a shock ofrecognition, self-consciousness, and concern for the dysfunctions in his or her own thought processes. ProfessorKahneman’s work invites — and occasionally demands — serious introspection by executives who profess to careabout the quality and consistency of their decisions.While graciously crediting collaborators and colleagues, Professor Kahneman has strong personal perspectives abouthow the discipline he helped create has evolved. The challenge of how — and where — psychologists should drawthe lines between intuition, cognition, and emotion is one that clearly haunts his thoughts about thinking.Professor Kahneman talked with strategy+business over coffee in Cambridge, Mass.S+B: In your classic work on inconsistencies in individual decision making, the focus seemed to be on thefact that people make irrational choices even when they have pretty good information.Photograph by Matthew SeptimusSeite 1 von 6Daniel Kahneman: The Thought Leader Interview31.12.2003http://www.strategy-business.com/press/article/03409?tid=230&pg=all
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KAHNEMAN: When you are interpreting old results or old thoughts, you have to think what was in the background ofthe scientific conversation at the time. And at that time, in the 1970s, irrationality was really identified with emotionality.It was also obvious that a lot of explicit reasoning goes on: It was absolutely clear to us that people can compute theirway out of some things. But we were interested in what comes to mind spontaneously. That led to the two-systemtheory.S+B: Can you describe the two-system theory?KAHNEMAN: Many of us who study the subject think that there are two thinking systems, which actually have twovery different characteristics. You can call them intuition and reasoning, although some of us label them System 1 andSystem 2. There are some thoughts that come to mind on their own; most thinking is really like that, most of the time.That’s System 1. It’s not like we’re on automatic pilot, but we respond to the world in ways that we’re not conscious of,that we don’t control. The operations ofSystem 1 are fast, effortless, associative, and often emotionally charged; they’re also governed by habit, so they’redifficult either to modify or to control.There is another system, System 2, which is the reasoning system. It’s conscious, it’s deliberate; it’s slower, serial,effortful, and deliberately controlled, but it can follow rules. The difference in effort provides the most useful indicator ofwhether a given mental process should be assigned to System 1 or System 2.S+B: How did you begin your research into the two systems?KAHNEMAN: In our first paper, Tversky and I did a study of the statistical thinking of professional statisticians whenthey’re thinking informally. We found what we called the Law of Small Numbers, a term we coined in 1971 to describehow people exaggerate the degree to which the probability distribution in a small group will closely resemble theprobability distribution in the overall population. And we also found that people, experienced statisticians, do not applyrules that they’re aware of in guessing the probability of statistical outcomes.S+B: So even “good” statisticians can be “bad” statisticians.KAHNEMAN: That’s right. When they’re not computing seriously in System 2 mode, they rely on their intuitions for thekind of simple problems we gave them. We were hoping that, where things really mattered, they would replace theirintuitions with computations. Yet what was striking to us was that even people who should know better were makingthose mistakes.What’s RiskyS+B: Has your perception of risk and the meaning of risk evolved or changed since you began doing thiswork?KAHNEMAN: The perception of and reaction to risk previously had been seen as emotional.S+B: Not just seen as emotional; dismissed as emotional.KAHNEMAN: Yes, exactly right. Our innovation was that we identified some categories of risk that were the result ofcertain cognitive illusions. That was a novelty and that got people excited. But it’s only part of the picture. There is analternative way of looking at this that is becoming much more fashionable. There’s a paper that I really like a lot. Thetitle of it says the whole story: “Risk as Feeling.” The idea is that the first thing that happens to you is you’re afraid, andfrom your fear you feel risk. So the view of risk is becoming less cognitive.S+B: So it’s not that generalized emotion influences decision making. It’s that one emotion — fear — distortsthe perception of risk and introduces error into decision making.KAHNEMAN: What actually happens with fear is that probability doesn’t matter very much. That is, once I have raisedthe possibility that something terrible can happen to your child, even though the possibility is remote, you may find itvery difficult to think of anything else.S+B: It’s like a Lorenzian imprinting of goslings: The phenomenon of fear imprints on a decision maker.KAHNEMAN: Emotion becomes dominant. And emotion is dominated primarily by the possibility, by what mighthappen, and not so much by the probability. The more emotional the event is, the less sensible people are. So there isa big gap.S+B: You’re saying that the shadow cast by a worst case overwhelms probabilistic assessment?Seite 2 von 6Daniel Kahneman: The Thought Leader Interview31.12.2003http://www.strategy-business.com/press/article/03409?tid=230&pg=all
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KAHNEMAN: We say that people have overweighted the low probability. But the prospect of the worst case has somuch more emotional oomph behind it.S+B: So even experts make cognitive mistakes. But experts and executives in organizations don’t makedecisions in isolation. They make decisions in meetings and committees and groups. Do we have thecounterpart of System 1 and System 2 thinking in groups as well as individuals?KAHNEMAN: We know a lot about the conditions under which groups work well and work poorly. It’s really clear thatgroups are superior to individuals in recognizing an answer as correct when it comes up. But when everybody in agroup is susceptible to similar biases, groups are inferior to individuals, because groups tend to be more extreme thanindividuals.S+B: So it’s a positive feedback loop. In a group, you get an amplification of the extremes.KAHNEMAN: You get polarization in groups. In many situations you have a risk-taking phenomenon called the riskyshift. That is, groups tend to take on more risk than individuals.We looked at similar phenomena in juries. You collect judgments from the individual members, then you have themdelivered, and then you look at the result compared to the median judgment of the group. It’s straightforward whathappens: The group becomes more extreme than the individuals.S+B: Why does this occur?KAHNEMAN: One of the major biases in risky decision making is optimism. Optimism is a source of high-risk thinking.Groups tend to be quite optimistic. Furthermore, doubts are suppressed by groups. You can imagine the White Housedeciding on Iraq. That’s a situation where it’s easy for somebody in the administration to think, “This is terrible.” It’sequally easy to understand how someone like that would suppress himself. There is a tendency and the incentive tosupport the group. That underlies the whole class of phenomena that go by the label of groupthink.S+B: What about decisions relating to asset allocation and financial investments? That strikes me as a perfectplayground for some of these ideas on the relative sobriety of the individual versus the extremism of thegroup — such as the corporate investment committee.KAHNEMAN: No, no. They are not the same dynamics. When you’re looking at the market and investmentcommittees, you’re really talking about the dynamics of competing individuals. We really should separate those cases.S+B: But I’m looking at the management committee, I’m looking at the jury, and I’m looking at the investmentcommittee, and they all seem to be weighing evidence and evaluating risk. Their similarities seem to outweightheir differences.KAHNEMAN: I’m a psychologist, so I start at the individual level and I look at individual-level biases or errors. Then Ilook at the group and I say, What happens in the group? How is the group structured? What are the incentives? Whatdo people do to each other in the group situation that would either mitigate or exacerbate risks? Then there are marketthings where people respond to each other.S+B: What you’re describing is an internal marketplace where groups come to a consensus about — or atleast some sort of agreement about — the risks and rewards associated with their decisions.KAHNEMAN: That’s correct. But remember that the internal incentives that shape how the group perceives risks andrewards may be very different from the reality of the risks and rewards in the external marketplace. Those incentivescan distort risk perception.S+B: Do you think the dysfunctions of group decision making are worse than the cognitive dysfunctions ofindividual decision makers?KAHNEMAN: That depends on the nature of the decision, the individuals, and the groups. But I strongly believe thatboth individuals and groups need mechanisms to review how their decisions are made. This is particularly importantfor organizations that have to make many significant decisions in a short amount of time.Business DecisionsS+B: How much interaction have you had with business leaders about this? Do you get senior executivesasking, Look, we make a lot of decisions, we have to assess risk. What insights can you give us into how todo better risk assessment as individuals and as groups? Are there ways for us to become aware of ourSeite 3 von 6Daniel Kahneman: The Thought Leader Interview31.12.2003http://www.strategy-business.com/press/article/03409?tid=230&pg=all
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biases, either by setting up checklists or learning how to frame things better?KAHNEMAN: I’m very impressed, actually, by the combination of curiosity and resistance that I encounter. The thingthat astonishes me when I talk to businesspeople in the context of decision analysis is that you have an organizationthat’s making lots of decisions and they’re not keeping track. They’re not trying to learn from their own mistakes;they’re not investing the smallest amount in trying to actually figure out what they’ve done wrong. And that’s not anaccident: They don’t want to know.So there is a lot of curiosity, and I get invited to give lots of talks. But the idea that you might want to appointsomebody to keep statistics on the decisions that you made and a few years later evaluate the biases, the errors, theforecasts that were wrong, the factors that were misjudged, in order to make the process more rational — they won’twant to do it.S+B: Are people introspection-averse, or are they risk-averse? You’re a psychologist; you say your unit ofanalysis is the individual. Why don’t individuals want to know?People look at mirrors.KAHNEMAN: But when they have made a decision, people don’t even keep track of having made the decision orforecast. I mean, the thing that is absolutely the most striking is how seldom people change their minds. First, we’renot aware of changing our minds even when we do change our minds. And most people, after they change theirminds, reconstruct their past opinion — they believe they always thought that. People underestimate the amount towhich their minds have changed. Now in addition, people in general, when they have been persuaded of something,they think they always thought that. There’s very good research on that.S+B: We’ve just lived through one of the biggest bubbles in history. We both know people who said, “I putmoney in dot-coms or telecoms at their peak. What was I thinking?”KAHNEMAN: Oh, many people will admit that they made a mistake.But that doesn’t mean that they’ve changed their mind about anything in particular. It doesn’t mean that they are nowable to avoid that mistake.S+B: So your bet, based on your study of how individuals and groups make decisions, is that the stockmarket bust is not going to fundamentally change how people think about risk.KAHNEMAN: For a long time it’s going to have the effect of people getting burned by a stove. There’s going to be aneffect at the emotional level, and it could last for a while.S+B: But their mind hasn’t changed. So you think it’s an emotional phenomenon, it’s a System 1?KAHNEMAN: I think that is entirely based on emotion.S+B: Do we want to use Freudian, self-destructive explanations for why people rely on flawed intuitions inmaking decisions, rather than on their statistical expertise?KAHNEMAN: Oh, no, God forbid!S+B: Well, how about using evolutionary psychology? Maybe it makes sense that humans have evolved acognitive bias toward drawing inferences from small numbers.KAHNEMAN: You can always find an evolutionary quotation for anything. But the question is whether it’s functional,which is not the same as being evolutionary. There might be some environment in whichit’s dysfunctional, but mainly it’s inevitable.But, you know, there’s also the issue of perception, which links to intuition. Perception evolved differently than eitherintuition or cognition evolved.S+B: Now it seems like we’re dividing decision making into three systems: there’s the emotional stuff; there’sthe rational-computational system; but there’s also a perceptual system.KAHNEMAN: Yes, I think of three systems. In my current perspective, the question I ask is, What makes thoughtscome to mind? And some thoughts come to mind much more easily than others; some really take hard work; somecome to mind when you don’t want them.Seite 4 von 6Daniel Kahneman: The Thought Leader Interview31.12.2003http://www.strategy-business.com/press/article/03409?tid=230&pg=all
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Decision AnalysisS+B: When you began your research in the psychology of decision making, the business world was intent onmaking the managerial decision process as rational as humanly possible.KAHNEMAN: The rational model is one in which the beliefs and the desires are supposed to be determined. We werereal believers in decision analysis 30 years ago, and now we must admit that decision analysis hasn’t held up.S+B: Didn’t your own research help kill it? The essence of your work seems to be the ongoing tensions andcontradictions between System 1 and System 2 thinking. That makes it almost impossible for rational System2 thinking to win out.KAHNEMAN: That’s not quite true. Our research doesn’t say that decision makers can’t be rational or won’t berational. It says that even people who are explicitly trained to bring System 2 thinking to problems don’t do so, evenwhen they know they should.S+B: Howard Raiffa, a father of formal decision analysis, basically recanted on his original work in the 50thanniversary issue of Operations Research. He argued that decision analysis didn’t have nearly the impact hefelt it could have had on managerial thinking.KAHNEMAN: And I think it’s very clear why that happened, but it was not clear then.S+B: Does this obviate all the decision analysis courses — all the drawing of decision trees — that studentstake in graduate business programs?KAHNEMAN: It doesn’t mean you shouldn’t take decision analysis. It just means that decision analysts are not goingto control the world, because the decision makers, the people who are in charge, do not want to relinquish theintelligence function to somebody else. After all, in principle, under decision analysis, there would be somebodygenerating probabilities, and the decision makers would look at the trade-offs and decide about the assignment ofutilities. In addition, the decision maker would have a managerial function, to ensure that the whole thing is done right.And that is absolutely not the way it is. Decision makers don’t like decision analysis because it is based on that ideathat decision making is a choice between gambles.S+B: That’s a wonderful phrase, “choice between gambles.” Is it more important to influence the choicebetween gambles, or to make a choice between gambles?KAHNEMAN: I think decision makers, in business and elsewhere, just reject the metaphor altogether. Managers thinkof themselves as captains of a ship on a stormy sea. Risk for them is danger, but they are fighting it, very controlled.The idea that you are gambling is an admission that at a certain point you have lost control, and you have no controlbeyond a certain point. This is abhorrent to decision managers; they reject that. And that’s why they reject decisionanalysis.S+B: So what should we do instead?KAHNEMAN: That’s why you ought to think of systems. There are ways of thinking about a problem that are betterthan others. But I admit I’m less optimistic than I was before.S+B: Because?KAHNEMAN: Because I don’t think that System 1 is very educable. And System 2 is slow and laborious, and justbasically less significant, less in control than it thinks it is.S+B: What is it that you would most like senior managers who have influence over people’s lives and moneyto understand about your work?KAHNEMAN: If I had one wish, it is to see organizations dedicating some effort to study their own decision processesand their own mistakes, and to keep track so as to learn from those mistakes. I think this isn’t happening. I can see alot of factors acting against the possibility of that happening. But if I had to pick one thing, that would be it.Reprint No. 03409Author Profiles:Seite 5 von 6Daniel Kahneman: The Thought Leader Interview31.12.2003http://www.strategy-business.com/press/article/03409?tid=230&pg=all
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This article is from Winter 2003Click HERE to subscribe to strategy+businessMichael Schrage (schrage@media.mit.edu) is codirector of the MIT Media Lab’s e-Markets Initiative and a senior adviser to the MIT SecurityStudies program. Mr. Schrage is the author of Serious Play: How the World’s Best Companies Simulate to Innovate (Harvard Business SchoolPress, 2000).Page 1 2 3 4 5 6 AllNext >Magazine || enews || Search and Browse || Press Room || Reprints || Subscriber Services || HOMEAbout s+b || Subscribe to s+b || Contact s+b || Advertise in s+b || Privacy Statement©2003 Booz Allen Hamilton Inc.
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