The Psychology of Market Crashes: Should We Have Seen the Crash of 2008?

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

Many analysts claim that they knew we were headed for the crisis of 2008, but was it truly knowable? In this brief video segment, Kahneman explains hindsight bias and our need to explain past events. The full version of the interview can be watched hereA full transcript follows the video.

Morgan Housel: You've written about hindsight bias with the financial crisis in 2008.

Daniel Kahneman: Yeah.

Housel: What can you tell me about that?

Kahneman: There's something I actually find shocking. There are now quite a few people who say, "I knew there was going to be a crisis."

I think that's perverse. It's a perverse use of the word "know." That's because we use the word "know" for something ... when I believed in something, and my belief was true, those are the two conditions under which we're allowed to say the word "know." I believed it with very high confidence.

But in fact, they didn't know that there was to be a crisis. They thought there was going to be a crisis. Then there was a crisis, and then all of a sudden they "knew" it was going to be a crisis, but there were people who were just as smart, and as motivated and so on, who didn't think there was going to be a crisis.

What is very important about this is whether you conclude that the crisis was really knowable. Given the number and the quality of the people who failed to see it, the fact that there are many people now who are sure that they knew it doesn't convince me. I think it wasn't knowable.

It was much less knowable than we tend to think because of the ease with which we can explain it. Everybody who didn't predict it looks blind, in retrospect. That's hindsight.

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  • Report this Comment On July 03, 2013, at 9:20 PM, grahamsway wrote:

    To put it frankly, the Dr. isn't very convincing. Of course no one knew the 2008 upset was going to happen but there was plenty of evidence that the excesses were very likely going to unwind badly, potentially very badly.

    Pretty much every astute investor realized this, the issue wasn't the knowledge but the will to act on it in the face of a bubble expanding in one's face.

    While I did pretty well in anticipating the bust, I did not go unscathed. I shorted Hilton, which Blackstone took out at huge premium. I shorted Golden West Financial, which Wachovia took out. I even bought Citi days before the meltdown because I wrongly believed they were smart enough not to be so exposed to the garbage.

    Here's a current case for the doctor. While I don't know that an unwind of the excesses caused by the Fed's QE will end badly, I think the evidence shows that it is very likely and mReits are especially vulnerable. Here's a recent fool blog I did as to why:

  • Report this Comment On July 05, 2013, at 5:02 PM, SkepikI wrote:

    "Knew" a regrettable game of semantics. Plenty of us suspected (also a semantics game) and acted on our suspicions. Some belatedly, but then its axiomatic that the decline was precipitated by this suspicion AND MANY PEOPLE ACTING BELATEDLY on that suspicion. If they had not acted on their suspicion late, there would have been no decline eh?

    Brinksmanship is an elegant and fashionable thing in Bubbles. Nobody wants to look stupid and give up the last Six or two months of gains in the bubble, only to look REALLY STUPID because they didn't bail early enough when the overwhelming suspicion was eating away at their sleep.

    Just like Bonds a few months back hey Morgan?

    And as for you Bob, I am out of REIT bubble because I agree with you and have no need to be in one for my investing strategy. But no doubt to their detriment, not many will find their way to your prescient blog.

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