Prospect theory argued that people's degree of pleasure depends more on their subjective experience than objective reality, as the rational model of economics held.
A shopper, for example, might drive across town to buy a $10 calculator instead of a $15 one, but forgo the same trip to purchase a $125 jacket for $5 less, illogically believing the greater percentage saved on the calculator makes the trip more worthwhile.
Prospect theory led to "loss aversion," which explained why investors clung to losing stocks rather than sell. Investors were more likely to sell stock they purchased at $50 a share if it rose to $70 and seemed overvalued; but if they bought the same stock at $90 and it fell to $70, they were disinclined to sell, even if shares still seemed overvalued.
In an interview, Kahneman discussed the pitfalls of trying to beat the stock market, why he's worried about privatizing Social Security and other issues.
Q. In what ways do your theories explain the stock-market downturn of the past three years?
A. Prospect theory helps explain biases of beliefs like "optimistic overconfidence" - that people believe they can do what they, in fact, cannot do. When you have a situation where everybody believes they are above average, the markets are going to behave in a funny way.
And that was happening to a lot of people at the same time two to three years ago. There was a sense we were living in a new world. That always happens in bubbles. Bubbles tend to convince people this is something fundamentally new.
Q. Would you say the corporate accounting scandals contributed to the market bubble?
A. You'd expect in every bubble there would be a lot of crooks. It's hard to tell. I don't think the bubble itself was caused by the crooks. Things were happening, there was a readiness and willingness to believe in things, and then there were people who were taking advantage of them.
I'm not sure anybody can say somebody caused the bubble to occur or caused it to burst. Lots of people knew it was a bubble when it was going on. That's what we call "delusion of control." And that is recurrent. People are surprised the bubbles collapse so quickly. They think prices will go down gently and that will give them the hint and time to get out.
The psychology there is quite interesting. People have a lot of difficulty figuring out they are just like everybody else, and what they see, everybody else can see. And making allowances for the fact that you're one of many people looking at the same time.
Q. How do you think investors will behave in 2003?
A. What you're finding at the moment is this individual is very pessimistic and very cautious. The question you are raising is what will change this individual's mind? The problem with those changes are sort of self-referential. If the market starts rising, that rise in some sense expresses a better mood, but it also causes a lot of people to become more optimistic. I don't think anyone can really put his finger on it. I'm quite skeptical about the power of psychology to predict the market currently.
Q. In what areas of investing do you see behavioral economics having the most significant effect?
A. I could imagine where psychology is quite relevant is in the whole domain of advising individuals about retirement and savings. Policy questions that arise, for example, in the context of privatization. How is the privatization of Social Security to be done, if it is to be done at all? How much freedom should individuals have to play with their own savings?
These are difficult philosophical questions. But there are also psychological issues. The question of how rational people are going to be, are they going to be sufficiently risk taking, are they going to be too risk taking, are they going to be playing with the bubble, are they going to churn their accounts (buy and sell stocks frequently). There I would see a role for psychology, because that involves individual behavior.
Q. It sounds like you're wary of proposals to privatize Social Security.
A. I would certainly urge considerable caution in doing any privatization. My guess is at the moment, unless real precaution is taken, the people who are going to do very well with privatization are not necessarily the individual investors. There certainly will be an industry (of investor advising) growing around privatization, and I'm quite confident that industry will do well.
There are enough for a lot of red flags, that if privatization is to be done, it should be done with a considerable number of safeguards to prevent people from really damaging their portfolios.
Q. What general advice can you offer to investors, given their shortsightedness and lack of complete information about the market?
A. It's clear from the research of individual investors, the main mistake people make is they churn their accounts too much. They just do too much. And so, the advice to be diversified and not do too much is standard advice that people do not spontaneously follow.
But not taking that advice is costly. And how costly, this has been demonstrated in recent years ... and Internet trading has clearly made things worse in the sense of giving people the ability to do more without making them necessarily smarter about what they are doing.
Q. So investors shouldn't delude themselves about beating the market?
A. They're just not going to do it. It's just not going to happen.
Q. Do you see behavioral economics eventually supplanting the rational model?
A. I don't see the rational model being overturned. People haven't worked out completely how to do behavioral economics. This is definitely a minority movement. We are not taking over. But it's a minority movement that is growing and it has become respectable in the last few years. It's clearly going to grow faster.