Dr. Daniel Kahneman, winner of the 2002 Nobel Prize in economics for his work in prospect theory, joins us to discuss his book Thinking, Fast and Slow. 

In this segment, Kahneman discusses how we think about the past. We love to look back and explain the past, but are we just creating the illusion that the world is understandable? The full version of the interview can be viewed here. A full transcript follows the video.

Morgan Housel: What are some other examples of how I fool myself when I remember the past?

Daniel Kahneman: I think that's the main one, but there are others. Let's not spend too much time on colonoscopies; let's discuss investing.

In the context of investing, people don't know how well they have done. There is just a lot of self-delusion that goes on when people evaluate their performance. That's an example, and an important example.

Then, in just about everything, how well the story ends is the key to how it's evaluated in the past. It's true, by the way, in presidential politics. In presidential politics, what happened in the first three years has very little impact on election results. It's really what happens, and how well the economy is doing and whether it's improving during the last year, that determines elections.

In a lot of places, our memory just doesn't correspond to the facts.

Housel: Is that why we remember Nixon differently than Clinton?

Kahneman: Well, I think there are many reasons we remember Nixon, but yeah.

Housel: If I have problems remembering the past, and I'm fooling myself, how does that shape my view of the future?

Kahneman: The main thing, the main mistake that people make, it's not so much in remembering the past. It's in thinking about the past. That I spent a lot of time on, in the book.

Whenever something happens and we feel we understand it, mostly ... we're surprised occasionally, but by and large, the world makes a lot of sense to us. It makes a lot of sense, because when things happen we find their causes, and it's OK.

Except that, if you compare our ability to explain the past with our ability to forecast the future, the difference is really quite dramatic. We explain the past with the greatest of ease, and we're really crummy at forecasting the future.

What happens here is hindsight, the ability to explain the past, gives us the illusion that the world is understandable. It gives us the illusion that the world makes sense, even when it doesn't make sense. That's a big deal in producing mistakes in many fields.