You can't always trust your brain

Daniel Kahneman, psychologist and Nobel Prize winner, has gotten a lot of attention from his book,  Thinking, Fast and Slow, which lays out how our brains work. The Wall Street Journal's Diane Cole asked him to apply the thesis to money management.

Typically, Kahneman says, people rely on blink-of-an-eye judgments, driven by emotion and impulse, in navigating life—even when we should be thinking "slow," using reason, deliberation and logic to weigh our options.

WSJ: In your book, you discuss overconfidence as a common pitfall. What impact does that have? 

MR. KAHNEMAN: Overconfidence is everywhere. We all have clear and certain beliefs, and our certainty is not impaired by the fact that other people hold contradictory beliefs. We just think they are biased. When optimism and overconfidence come together, you get many mistakes. Optimistic estimates can in retrospect seem almost delusional. One example is that people end up paying about twice as much as they originally expected to pay for kitchen renovations.

WSJ: Any advice on how to avoid overconfidence in financial decisions? 

MR. KAHNEMAN: I don't think individuals should be in the business of picking individual stocks, because they will be taken advantage of. What happens is that when the market is doing well, it is populated by geniuses who think they can try it for themselves. It's natural and inevitable that this leads to overconfidence and foolish actions.

WSJ: Can people learn from errors of financial overconfidence? 

MR. KAHNEMAN: The first thing for people to know is to accept the limits of their knowledge. When you're young, you have time to make up for financial losses. But when you are older, it is a very concrete matter. You should be thinking about how much you need to spend every month. And many investment professionals are quite aware of that, so they steer people on a path toward diminishing risk, because those people don't have enough time to recover a loss.