Daniel Kahneman, who passed away in March, leaves behind an important legacy that transformed our understanding of human behaviour and decision-making. His groundbreaking work in the field of behavioural finance challenged the conventional wisdom of economics, reshaping it to accommodate the complexities and vulnerabilities of the human mind. Kahneman’s insights not only garnered him the Nobel Prize for Economics in 2002, but also provided invaluable tools for policymakers and investors.

Kahneman’s academic journey began in earnest at the Hebrew University of Jerusalem, where he studied psychology. He later earned a PhD in psychology from the University of California, Berkeley. His early work focused on visual perception and attention, but it was his collaboration with Amos Tversky that steered him towards behavioural finance.

Together, Kahneman and Tversky developed the groundbreaking Prospect Theory, a model which helps to explain how risk can influence decision making. Published in 1979, Prospect Theory revealed that people value gains and losses differently, which can lead to decisions being reached that traditional economic theories would have classed as “irrational”. This work provided a more accurate framework for understanding real-world behaviour, particularly in the realm of investment decision making.

Another of Kahneman’s key contributions was in developing the concept of “loss aversion” – the idea that losses loom larger than gains. He found that the pain of losing can be twice as powerful as the pleasure of gaining, which helps to explain various market behaviours, such as why investors are sometimes reluctant to embrace risk, despite the overwhelming evidence that demonstrates that it leads to higher returns over the longer term.

In addition to Prospect Theory, Kahneman’s research extended into various aspects of human cognition and well-being. His book, “Thinking, Fast and Slow”, published in 2011, became a seminal work, summarising decades of research and introducing these concepts to a broader audience. The book explains how our brains operate with two different systems of thought, each of which can be used effectively in different settings. System 1 is fast and intuitive and can involve impulsive or emotional decisions, whereas System 2 is slow and deliberative, promoting careful analysis and logical reasoning. The latter works well in investment decision making, while the emotional aspects of system 1 can cloud one’s judgement and lead to poor outcomes. Understanding this can be really helpful for all investors.

It is likely that Kahneman’s work was influenced by his own experiences as a child during World War II. His family moved frequently to escape the Nazi occupation and these early encounters with danger and insecurity may have stimulated his interest in how people manage risk and uncertainty. This personal history gave him a unique sensitivity to the human aspects of economic behaviour, which stood in stark contrast to the impersonal, “rational” models which dominated the classical economic theories that predated his work.

The Cavendish investment approach aims to mitigate the pitfalls identified by Kahneman’s valuable research, by bearing in mind the many implications of his findings in the way we think about risk and portfolio construction. This role can be invaluable at times of financial market volatility. The Cavendish Investment Committee is guided by decades of evidence about what drives asset prices in the long run and builds portfolios that can harness the power of financial markets to the benefit of our clients. Nevertheless, all that hard work can count for nothing if the behavioural expectations of clients are not set appropriately at the outset, and reiterated when markets wobble and confidence is tested.

In reflecting on Kahneman’s legacy, it is clear that his work has had a lasting impact on both theory and practice. By revealing the often-irrational nature of human decision-making, he challenged long-held assumptions and provided a richer, more nuanced understanding of economic behaviour. His contributions should continue to inform and inspire future generations of economists, psychologists, policymakers and, perhaps most importantly, advisers and investors.