Morningstar Magazine - August/September 2018 - 61

This is from a very long distance, because
this is not really my field, but this is what I would
like to see happen.

Noise Reduction
Newcomb: You've reached this enviable point in

your career where you have the authority and the clout
and the recognition to sit back and think about
whatever interests you. What big questions are on your
mind now?

Kahneman: I've done a lot of work on biases,
the systematic errors that people make. In recent
years, I've become convinced that actually
there's something more important than systematic
error, and this is unsystematic error. We
call that noise. There is a random element, not
in the outcome, but in the making of the
decision that is very significant. It's very significant
for organizations, not only for individuals.

I'll give you the example that motivated
my interest. I convinced an insurance company
I was working with to run a study on their
underwriters. You present, say, 50 individual
underwriters with five or six realistic cases and ask
them to put a dollar value on each case. I
asked the executives, suppose you take a random
pair of underwriters who have seen the same
case, by how much would you expect their dollar
values to differ? The common answer was
that 10% was reasonable. You'd expect people to
agree within 10%. But when you actually compute
the statistics, you get 50%.
There is a lot more variability and a lot more noise
than anybody was aware of. The company
was unaware that it had that problem. When
underwriters can differ on average by 50%, they
may not be worth having. It is entirely
possible that an algorithm, even an unsophisticated algorithm, will do better because the main
characteristic of algorithms is that they
are noise-free. You give them the same problem
twice, they'll give you the same solution.
People don't.
What I'm interested in now is restoring the
balance in the way that people think of
error, so that they'll be much more conscious

of noise. We always think of biases, and we don't
put enough weight on noise reduction. That's my
personal passion at this time.

Audience member: Do you think optimism
is a learned behavior or is that something that
is inherent?

Newcomb: How are we going to be able to see

Kahneman: Optimism, I think, is mostly something
you're born with. It's actually a very good
thing to be born with. Optimists are healthier and
happier, and optimists live longer, apparently.
But you can't necessarily control it. There are some
cultural differences, though. I'm told that
Hungary is a place where optimists are considered
foolish. The United States has an optimistic
culture, and being a pessimist puts you at some
risk of social discomfort.

this work?

Kahneman: I am writing a book with two
colleagues; one of them, Cass Sunstein,
was a coauthor of Nudge. We hope to have a book
that will tell that story and will actually
change procedures. There are procedures that
organizations that make strategic decisions
can follow, and that people like underwriters can
follow, that reduce noise.
Newcomb: Let's take some questions from the
audience.

Audience member: When people are framing
current events, they often look at past
historical events, seeing similarities and then
rushing to judgments that the current
event will be exactly like the past event. How
can we counter that tendency?
Kahneman: This is the natural thing for
people to do. When something happens, memory
spontaneously and automatically goes to
something similar that happened in the past. The
answer is what I call broad framing. It is
not to stop with the first idea, not to stop with
the first association, but to try to expand
the range of consideration to other examples, to
other cases. Quite frequently, this will profoundly
alter the conclusion that you reach.

But clearly when big decisions are made, you
want both kinds. You want the optimists and you
want the pessimists, and you want an open
conversation about how they're thinking and what
makes them think what they do.
Audience member: If you could go back in
time and talk to a young Danny Kahneman, what
life advice would you give him?
Kahneman: When I look back at my career,
I think that I've been enormously lucky.
Telling people to try to be lucky is very poor advice.
Yet that's the main thing that determines the
difference between very successful careers and
somewhat less successful careers. When you trace
it back, you'll find a lot of luck. K
Sarah Newcomb is a senior behavioral scientist
with Morningstar.

Audience member: You seem to be referring to
regret minimization only with respect to loss
aversion. What are your thoughts on regret about
missing upside or missing profit?
Kahneman: You have hit on a bias in my
character: I'm a pessimist and tend to think in
terms of losses. But when I was working
on that, my colleague, who is a great optimist, was
always talking of the other kind of regret, the
missed upside regret, and of course that exists, too.
It turns out that when you have two portfolios like
the one that I described, one that has a very
significant beta and the other that has relatively
little, then one of them is likely to do better
than the market. We saw that as a partial solution.

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