“As we navigate our lives, we normally allow ourselves to be guided by impressions and feelings, and the confidence we have in our intuitive beliefs and preferences is usually justified. But not always. We are often confident even when we are wrong, and an objective observer is more likely to detect our errors than we are.”
-Daniel Kahneman, brilliant author of Thinking Fast and Slow, Nobel Prize winner.
Thinking Fast and Slow is an interesting (and technical book) by Nobel Prize winner Daniel Kahneman that collates Kahneman’s current understanding and body of knowledge about judgement, biases and decision-making processes. Anyone deeply interested in psychology, behavioural finance or statistics should have a read of this bestselling book.
The metaphor of two agents – System 1 and System 2
The book explores, in great detail, how we possess two basic systems associated with judgement and choice:
- System 1, does the fast thinking, it constantly constructs a coherent interpretation of what is going on around us at any instant. This system operates automatically and quickly, with little effort or no effort at all. There is no sense of voluntary control. Examples of when System 1 is in action: reading large words on a billboard, what is 2+2, detecting anger in someone’s voice. System 1 is intuitive and reactive.
- System 2, does the slow thinking, it allocates energy to the mental activities that demand it, including any complex computations. System 2 is associated with effort, concentration and choice. Examples of when System 2 is in action: focusing on one voice in a very noisy room, filling out your taxes, checking the validity of a complex argument or algorithm. System 2 is actually quite lazy, much more so than System 1, which causes us to use hunches and heuristics more often than not, often to our detriment when it comes to investing.
Here are a few interesting takeaways from this book about the way our mind works and what this means for our finances:
We see this in marketing all the time, Kahneman writes about an example of Campbell’s soup on sale. On some days the sale sign says limit 12 per person; other days there is no limit. On days when there is no limit posted, twice as many cans were purchased even though the sale price was exactly the same. In this case there is no anchor or starting point holding people back. Kahneman says we see anchoring in the real estate industry as well, when a homeowner is selling their home. Setting the sale price is the anchor and this anchor drives buyer behaviour and the negotiating process.
Kahneman writes “hindsight is especially unkind to decision makers who act as agents for others – physicians, financial advisers, third-base coaches, CEOs, social workers, diplomats, politicians. We are prone to blame decision makers for good decisions that worked out badly and to give them too little credit for successful moves that appear obvious only after the fact.” Investment decisions that seem to make sense at the time can look very irresponsible in hindsight.
On illusions of validity and skill
Kahneman asks, after being introduced to a senior investment manager at a Wall Street firm, “when you sell a stock, who buys it?” Kahneman questioned the validity and skill of stock market traders, what information could sellers possibly have over buyers in an efficient market, hardening his perspective the financial trading industry has been largely built on an illusion of skill. If all assets in the stock market are supposedly priced correctly, then no one can expect to either gain or lose by trading in the short-term because the information available is the same for both parties. This notion confirms why many individual investors lose money by trading in the short-term, an achievement Kahneman writes “that a dart-throwing chimp could not match.” In our highly efficient stock markets then, educated guesses on short-term prices are no more accurate than blind guesses including those made by professional money managers. The lesson, avoid trading.
On use of formulas
In Thinking Fast and Slow Kahneman not surprisingly has a bias himself, to replace human judgement with formulas and scoring ratios where possible. This would reduce the role intuition and emotion has with major decisions.
On loss aversion
System 1 responds strongly to losses over gains, we’re wired this way and most psychological studies support this. As a consequence we tend to think and act in the extremes (a loss or a gain) with little compromise in between. It is not surprising then that most investors are fraught with emotion when it comes to investing decisions instead of being calm and rational.
Kahneman cites a survey of CFOs from major corporations who were asked to predict the S&P 500 performance the following year. The study found their estimates and the actual S&P 500 results had no statistical relationship.
These are just a few of the biases Kahneman writes about in Thinking Fast and Slow.
Fast thinking (using System 1) is not wrong in fact in many cases it is absolutely necessary in our lives. Yet when it comes to investing you should rule out using System 1 by recognizing when it’s taking over. Using System 1 for investing will often result in poorer decisions based on emotions and reactions, being far less rational than we need to be.
“We are born prepared to perceive the world around us, recognize objects, orient attention, avoid losses, and fear spiders” –Daniel Kahneman.