Retirement

3 Ways The Late Daniel Kahneman Has Improved Your Life (Whether You Know It Or Not)

There are people who change your life because of their proximity to you and yours—and then there are those who change your life without you even knowing they exist. Regardless of which of those categories Daniel Kahneman fits into for you, he’s changed your life, just as surely as he has demonstrably changed mine.

Kahneman, the Israeli-American Nobel-prize-winning psychologist-turned-economist, passed away this week at the age of 90. And, while his legacy looms far greater than a bulleted blog post, I hope to personalize his worldwide impact for you with three ways Daniel Kahneman has changed your life, whether you know it or not, accompanied by three book recommendations. We’ll start with the least personal and conclude with the most:

1. He upended the field of economics.

Kahneman, along with his best friend and lifelong research partner in psychology, Amos Tversky, studied human decision-making and were the first to question the presumption upon which hundreds of years of economics was based—the falsehood that humans defaulted to rational behavior. They illustrated how it’s really quite the opposite.

If you ever took a single economics course in high school or college, you’re likely familiar with the phrase “all things considered equal.” Kahneman and Tversky showed the world that they never are. How does this impact you? The better question is, how doesn’t it?!

Even if you have never studied economics or seen its value, economists are actively involved in almost everything that touches your life—politics, policy, finance, education, housing, advertising, marketing, and even social media. By changing the way that economists think and helping them better understand how we all think, Kahneman’s insight and influence have permeated, well, everything.

The book I recommend starting with here is The Undoing Project, by Michael Lewis. It is an approachable narrative that introduces us to the life, friendship, and work of both Kahneman and Tversky. Unlike most books about behavioral economics, it really is a page-turner.

2. He changed the way we invest.

The impact of Kahneman’s thinking on investing can barely be contained in a book, much less a bullet point, but there are two ways I’ll suggest that are the most important and practical, respectively. The most important, I’d argue, is that while our foremost objective in investing is to gain returns, our investment behavior is more driven by our fear of losses. Indeed, Kahneman showed that the pain of loss is twice as powerful a motivator as the joy of gain. He helps us understand WHY our human tendency is to buy high and sell low rather than the preferable inverse.

Practically speaking, though, how do most people in the U.S. invest? Through their 401(k) or other company-sponsored retirement plan. The way we invest in our retirement plans has been changed dramatically, thanks to Kahneman’s influence applied through the work of another Nobel-prize-winning economist, Richard Thaler, explicated in his book, Nudge, co-authored with Cass Sunstein. There are at least three specific and fundamental changes to the way 401(k) plans are administered that this work has directly influenced:

  • We have fewer investment choices. Although we’ve all thought “the more options the better,” we learned that having too many choices is possible, leading to analysis paralysis. Therefore, we’ve seen eventual retirees make better choices when they have fewer options.
  • Our default to inaction now works in our favor. All retirement plans used to be opt-in, but now many are opt-out. What’s that mean? A new employee has a myriad of choices to make when being onboarded to a new company. Historically, the last choice we were asked to make was whether we wanted to cede a portion of our hard-earned pay for a seemingly distant future that may never come—we had to choose to opt-in to our 401(k) contribution, even before we faced the analysis paralysis of the investment choices within. Most people didn’t. Many plans now have an opt-out default, requiring a new employee to actively choose not to save for the future. Lo and behold, most people still choose the path of least resistance by making no decision, but now that indecision works in their favor.
  • Plans can automatically increase your contributions over time. Through the field of behavioral economics, we’ve learned that it is easier to commit money that we won’t receive until the future than money we already have. Therefore, through auto-escalation options in retirement plans, we can choose to increase our future contributions in the present. For example, let’s say you are currently contributing 5% of your compensation to your 401(k), but you’ve determined that you need to be saving 10% to meet your goals. Instead of increasing your contribution to 10% today (and feeling the pain in your paycheck), you can choose to automatically increase your contribution by 1% at the beginning of every year—when you’ll likely also receive a cost-of-living increase in pay. You’re improving your future without feeling the pain today.

3. He changed the way we see and understand ourselves.

While Kahneman’s work has directly and indirectly influenced the way the world operates from an economic perspective, his seminal thesis has a far more deeply personal impact on how we think about ourselves. In the tome that originally shared Kahneman and Tversky’s work with the world, Thinking, Fast and Slow, Kahneman explains that our brains have two distinct processors. These are not the proverbial right and left hemispheres, but System 1 and System 2.

System 1 is that fast, subconscious, and immediate emotional processor in our brain, while System 2 is the more thoughtful and rational processor. While we’d surely prefer to enlist our System 2 for all financial decisions, research suggests that our System 1 is most often in the driver’s seat. Indeed, 80% of our financial (and other) decision making is driven by System 1. Furthermore, when the two systems are in conflict, System 1 always wins.

Therefore, the whole notion that the financial industry has long promoted—that emotion serves no role in financial choices and should be ignored—is a scientific impossibility.

And the power of System 1 and its distinction from System 2 is insight that has implications far beyond our finances. Indeed, it helps us better understand ourselves and those we interact with—our spouses, partners, children, friends, and co-workers. We are inherently emotional beings; the better we understand that, the better we understand everything.

One of the few things (maybe the only?) that I’ve said that has never (to my knowledge) inspired disagreement is that personal finance is more personal than it is finance. This began as an anecdotal observation in my work as a financial planner, but it is Kahneman who has helped the world understand how and why that is true—and what we can do about it.

May he rest in peace.

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